Is this the return of the inflation monster?

Alongside flared trousers and standpipes in the street, anyone who remembers the 1970s will recall the runaway cost of living. As the Bay City Rollers went to No.1 with Give a Little Love, inflation in Britain peaked above 26% per year. For every £1 you spent in the summer of 1974, you needed £1.26 by July 1975. Over the next half-decade, prices in the shops just kept rising. Inflation averaged nearly 15% per year right up until the start of 1981. By then, the economy had ground to a halt. The number of people out of work reached nearly three million. Could wipe-out inflation be about to strike again?

The return of wipe-out inflation: is history repeating itself?

History is littered with monetary crises. Many run far beyond what we suffered 30 years ago. Time and again, however, the root cause is the same: a bubble in the supply of money. It sends the price of real assets and raw materials shooting to the moon.

There are many reasons why a government might let the banks pour more and more money into circulation to keep house prices buoyant, help fund its own spending, or make the economy look as though it's growing. But the outcome is always the same. As more money floods the economy, each unit of money loses value. So you need ever more money to keep up with the cost of living. To help you stay ahead, either the banks keep lending more cash or the government keeps printing more worthless notes.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Germany in the 1920s is often cited as the best example of so-called "hyperinflation". The Berlin government printed huge quantities of worthless paper money to pay off its debts after World War I. People needed a wheelbarrow full of money to buy one loaf of bread; the joke was that thieves would steal the wheelbarrow and leave the pile of worthless money behind.

But it was Hungary that set the benchmark. During the chaos following the end of World War II, inflation rose so quickly that prices in the shops doubled every 15 hours. Between dawn and sunset, the value of the pengo the Hungarian currency in the 1940s fell by half. The panic culminated in the printing of a bank note worth one quintillion pengos. That's a one followed by 18 zeros. That makes Weimar Germany, where prices merely doubled every 49 hours, look like an also-ran. The best the Reichsbank could manage to print was a trifling 100 trillion note.

In Argentina during the 1980s, inflation reached an annual 5,000%. Brazil suffered inflation of 4,000% in 1994. I saw hyperinflation at work in Peru in 1991, where a fistful of US dollars would make you a millionaire in Peru's worthless currency, the inti. And I saw how hyperinflation changes people's behaviour.

First, investors seek out alternative ways to store their wealth, choosing foreign currencies and real assets, such as gold and property. The rate of spending shoots higher during inflation, too. Economists say that the "velocity of money" accelerates. People spend their cash as soon as they get it, before it loses value. And getting credit becomes almost impossible. Making a loan is the dumbest thing anyone could do when the debt will be worth less tomorrow than it is today.

The return of wipe-out inflation: what are the central banks doing?

For the world's governments and their friends at the central banks, hyper-inflation is the stuff of nightmares. That is why they want stable prices above all other things. It is their job to keep the inflation monster in its cage even while they feed it, just a little each day, by growing the supply of money.

Take the Bank of England (BoE). While warning us about runaway property prices and the dangers in taking on too much personal debt, it has let the money supply grow by 10% per year since spring 2005. That's faster than Europe, America and Japan faster than any major economy bar China.

But it isn't just the BoE. Most of the central banks are guilty of flooding the world with too much money. And at least the British Government admits to how much extra cash is being pumped into the economy through the money supply. In the US, the Federal Reserve stopped reporting the growth in the money supply, or M3, earlier this year. M3 may look like an obscure piece of data, but it measured the rate of growth in "broad money" in the world's largest economy notes, coins, cash on deposit, short-term loans and bonds.

The decision to stop reporting the growth in US dollars, said one commentator, was like General Motors not saying how many cars it sells. And you don't need to be paranoid about government conspiracies to guess why this happened. In 2005, the US Federal Reserve said that M3 was growing at a rate of 7.5% per year. By contrast, the narrower measure of just notes and coins, M2, rose by only 4%. The Fed continues to publish its M2 data. But few serious analysts are fooled.

Here in London, Crispin Odey the leading investment fund manager says global interest rates should now be around 8%. The threat of inflation posed by the oversupply of money needs to be challenged. Higher interest rates would slow the growth in lending and debt that has fuelled so much of the bubble in money. "Central bankers are starting to get frightened at what they see, and want to raise interest rates," says Odey. "[But] the fears of over-indebted Western economies being skittled over by rising interest rates will only ensure that monetary policy remains accommodating."

The return of wipe-out inflation: what is the true cost of living?

In other words, the major Western economies have created a bubble that they can't afford to burst. The problem of monetary inflation is going to get much worse before it gets better. The evidence is that it is already doing so. A report by Ernst & Young found that over the past five years, the average UK family has been subject to mortgage costs up by 66%, motoring costs up by a third, and some household utility costs up by 50%.

Officially, annual inflation is running at 2.5%. But if you can't match that to your own cost of living, you're not alone. "Fixed monthly household costs continue to outstrip inflation and have risen by more than 30% in the last five years," says Ernst & Young's Tim Sleep. And since when did your council-tax bill have the decency to increase in line with the Consumer Price Index (CPI) the measure of inflation now used by the Government?

You might wonder how this Government, like others all over the world, gets away with claiming that inflation is running lower than your own experience tells you. The real swindle, says the Swiss-based Bank of International Settlements (BIS), lies in removing property costs from the cost of living data. "The [CPI] data may not be reliably measuring the underlying inflation trends," says the BIS. "In most countries, the costs of housing services have been rising sharply, but these tend to be badly measured or even ignored in the calculation of consumer-price indices."

It's easy to see what effect removing property costs from the inflation data has on the official cost of living. On average, house prices in Britain have trebled since 1996. Looked at the other way up, this means that each pound in your pocket is now worth just one third of what it was ten years ago in terms of bricks and mortar. But according to the official data, inflation is running at only 2.5 pence in the pound per year!

However hard the central bankers try, they can't fudge the inflation figures for ever. Recently we saw that UK inflation has reached its highest level in ten years. And it's not alone. Thanks to soaring commodity prices, input costs for manufactured goods are rising everywhere. Even China is starting to see the cost of living rise quickly. And it's there, in the world's fastest-growing economy, that the threat of rising prices could tip us into runaway inflation.

The return of wipe-out inflation: what will the effect of Chinese wage demands be?

China has 1.3 billion people, almost a quarter of the world's population.

They're willing to work for less than £3 per day on average. So far, this has given us cheaper goods and gadgets. But what if the world's low-cost workshop is now forced to push up the price of its exports? China's impact on global inflation could be devastating.

Manufacturing to Western standards for just a fraction of the price has seen China's economy grow by 11% over the last year. The Chinese money supply has grown by 18.4% and its labour market also appears to be developing fast. China has more people enrolled at university than the United States and as expertise and aspirations rise, so too do wages.

Salaries for managerial and technical staff in China are increasing at

15%-20% per year, according to management consultants, McKinsey. Manufacturing wages grew by 14% last year. China's workers are getting more picky, too. "We used to get 500 applications for every 100 jobs advertised," says an executive of a Japanese food company working in Shandong Province. "Now we can't even find ten applicants."

What's more, the number of people leaving their small farming villages to find work in the big Chinese cities has started to fall. Thanks to the drain of labour to the coastal factories, inland farmers' incomes are starting to rise. This state of affairs could mean a rise in the cost of feeding China's factory workers. Reports in the Asian press say that they are already moving from one job to another quickly, looking for higher wages. Now add in the soaring cost of raw materials. China, like Britain, can't produce all the oil that it needs. But its demand is increasing fast. As Marc Faber, editor of the Gloom, Boom and Doom Report, comments: "China's yearly per-capita consumption of oil is 1.7 barrels. US per capita consumption is 27 barrels... The US has 740 vehicles per 1,000 people. In China, there are three, and in India there's one. Demand is going up, and [oil] prices will be much, much higher."

Oil is just one in a whole range of commodities that have soared since 2002 aluminium, zinc, copper, nickel, gold, silver. Just last month, China's steel mills had to accept a 19% increase in the price of their iron-ore supply. So rising wages demands and raw material costs are now starting to feed into China's inflation numbers. Producer price inflation jumped to 3.4% in June from 2.4% in May. Goldman Sachs expects consumer-price inflation to reach 3% by year-end. And Mervyn King, governor of the Bank of England, recently noted the upward pressure on Chinese goods imported into Hong Kong.

The return of wipe-out inflation: what will this mean for Britain?

If China's discount prices are under threat from higher raw material and labour costs, what about the cost of living here at home? British businesses can't absorb rising input prices for much longer.

Earlier this month, Stuart Rose, the chief executive of Marks & Spencer, warned that "costs in the [retail] business are going up quite considerably costs of rent, rates, fuel and cost of employees.

So businesses are under a bit of stress."

No doubt Rose hoped to temper City expectations of Marks & Spencer's sales growth. It's part of the art of being a shrewd executive. But he's right to point out the soaring price of fuel, rates and rent. Energy, taxes and property prices give the lie to Britain's currently "benign" inflation data. Just think what will happen when Chinese inflation starts showing up in your cost of living, too.

Rob Mackrill is editor of financial newsletter True Wealth. To find out more about True Wealth, visit

www.true-wealth.co.uk.

How to surf the inflation wave - without getting wiped-out

Gold has acted as a universal store of value throughout history. Whenever governments and banks have pushed the supply of money too high, too fast, its rarity has always meant it enjoys huge demand. As a result, gold proved the ultimate hedge against inflation last time around at the end of the 1970s and owning it today will protect you against the latest bubble in money. Plus it's easier than ever to invest in, either through bullion certificates, such as the ones sold by the Perth Mint (www.perthmint.com.au), or through a gold-backed exchange-traded security, such as Lyxor Gold Bullion Securities (GBS).

But while gold may be your first line of defence against the inflation beast, it's not the only asset that will help protect you. Those raw materials feeding China's booming economy have a strictly limited supply that can't be increased simply by adding a few zeros at the printing press. Maximising your exposure to real assets now will let you ride out the coming inflation, rather than getting swept

away by it.

There are lots of ways to play commodities, the easiest being to invest in an exchange-traded fund (ETF), note (ETN) or certificate that track one of the commodity indices. Which index you choose should depend on which commodities you think are likely to rise in price the most, as all have different weightings towards different assets. So far, hard commodities energy and metals have been the star performers. But many think that we could be primed for an explosion in the price of soft commodities agricultural products arguing that changing appetites in China and other developing nations, together with demand for crops to make biofuels, will send many agricultural prices soaring.

If you're bullish on softs, you could choose to track either the Reuters/Jefferies CRB Index (softs: 41%; metals: 20%; energy: 39%, which you can track via Lyxor CRB ETF (CRB.FP)), or the Dow Jones AIG Commodity Index (softs: 41%; metals: 26%; energy: 33%, track via iPath ETN (DJP.US)). The Dow index also has the highest weighting towards metals, while oil bulls could look at the Goldman Sachs Commodity Index (softs: 16%; metals: 11%; energy 73%, track via iShares GSCI ETF (GSG.US)). For investors who want to tailor their commodities exposure personally, there are products that track individual index sub-sectors or specific commodities, such as ABN AMRO's wide range of certificates (www.abnamromarkets.com).

You can also get commodities exposure by investing in the companies that mine or grow them, either individually or through a collective investment vehicle. One investment trust in this sector that looks particularly interesting is the Merrill Lynch World Mining Trust (MLW).

The trust's manager, Graham Birch, has a doctorate in geology and has run the fund since its launch. His strategy targets companies with strong cash flow and the potential to lift shareholder returns through dividend hikes and/or share buybacks. He also places emphasis on those companies producing resources that are in short supply. Birch expects China to continue to be a key driver of commodity markets and is a bull on gold, citing "stagnant" supply, growing investment demand and a possible fall in central bank sales. More than half the fund is invested in major diversified miners, including Anglo American, BHP Billiton, CVRD, Rio Tinto and Xstrata. So in one investment, you get exposure to many of the world's biggest and best mining companies.

On top of that, the trust looks cheap, as it's currently trading at a substantial discount of around 12% to the value of its assets.

A discount is expected for an investment trust and a few years ago, when few were interested in miners, the discount was greater (as you can see in the chart opposite). But during the latest bull run, the discount was often much smaller until the big sell-off in April, when it widened again. If we're in for a long-term commodities bull market as MoneyWeek believes we are this fund should not only track a range of companies that will benefit, but also offers the possibility of excess return if the discount closes again once the next leg of the bull run begins.

Rob Mackrill is editor of financial newsletter True Wealth. To find out more about True Wealth, visit www.true-wealth.co.uk.