Why inflation is making a comeback

Inflation has been held down across the world as global manufacturing has shifted to take advantage of low labour costs in China. This has resulted in historically low interest rates, encouraging consumers to push up the prices of assets from buy-to-let flats to Picasso paintings, says MoneyWeek editor Merryn Somerset Webb. But now inflation is making a comeback - and recent stockmarket turmoil could just be a taster of things to come...

What's the connection between the price of a Picasso and the cost of a day's labour in China? This might sound like a trick question but it has a very simple answer - inflation.

For the past decade or so the cost of getting anything made in China has not only been low but getting lower, which has allowed retailers in the West to cut their prices to levels that would have been unimaginable a few years ago.

Pop into any superstore today and you can pick up a Chinese-sewn pair of jeans for a fiver and a brand new Chinese-assembled DVD player for not much more. These amazing prices have meant that official inflation figures around the world have stayed down, allowing central banks to keep interest rates at historically low levels.

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When interest rates are low, people borrow. And once they have borrowed they spend, either on pointless consumer goods, which keeps the global economy growing, or on things they think might make good investments -assets that will return more than the rate of interest on their borrowings.

The lower the interest rate, the more things qualify as 'good' investments, so the result of the low inflation of the past decade has been a flood of money pouring into emerging-market equities, buy-to-lets in Bulgaria, fine wine and of course the art market, where prices have now surely hit bubble levels.

Two weeks ago, a Picasso portrait sold for an extraordinary $95m (£ 52m) - the second highest price ever paid for a painting -at Sotheby's in New York in a sale that generated more than $200m in under an hour. The night before, a Van Gogh sold for more than $40m at Christie's, and in the past year many works of art have set record prices.

Much of the investment world still appears to think this happy state of affairs can go on forever - that inflation will never really rise much again, that interest rates will stay low and the cash mountain available to buy overpriced art and the like will never quite dry up.

But they are wrong. Things are changing. For starters, the cost of getting stuff made in China isn't going down any more. In Shenzhen, the special economic zone near Hong Kong, the minimum wage is about to go up by more than 20%, which will have knock-on effects throughout the manufacturing sector.

At the same time, thanks to rising commodity prices, input costs have risen, as have freight charges and, in some cases, taxes.

The result, as the governor of the Bank of England pointed out two weeks ago, is that the cost of traded manufactured goods around the world is rising. The cost of services has been on the up for years in the West (you may be able to get a pair of jeans for a handful of change, but if you get someone to deliver a bunch of flowers you'll have to fork out at least £25). Add the two together and it is clear inflation is on the way back.

Once under way, inflation is very hard to stop: when workers see prices rising they tend to ask for higher wages, and when corporate profits are high (as they are now) they tend to get them, which pushes inflation even higher.

Note that in Britain consumers expect inflation next year to be well above the 2% target rate at 2.7%. In America, wages are rising at nearly 4% despite sluggish job growth.

The world's central bankers know what is going on and are increasingly biased towards raising interest rates to head off an inflationary spiral.

One member of Britain's monetary policy committee thinks it is time to start raising rates again, and recent statements from America's Federal Reserve and the European Central Bank have pointed the same way. And a few weeks ago, Australia's central bank surprised the market with a rate rise. The fact is the days of cheap money are over and the asset bubbles it created are nearly over too.

Last week we got a glimpse of how fast these bubbles can deflate as investors began to get cold feet about their more risky investments. Istanbul's market fell 9% in two days, for example. But there is bound to be worse to come as inflation expectations and then interest rates rise further.

Equities move faster than many other assets - don't forget that in 1987 the S&P 500 fell 29% in three days - but slower-moving investments such as paintings or property are no safer in this environment. It just makes them harder to get out of.

The man who bought the Picasso had better really, really love having it hanging on his wall because I doubt he is going to get his money back on it any time soon.

First published in The Sunday Times (21/05/2006)

Merryn Somerset Webb

Merryn Somerset Webb started her career in Tokyo at public broadcaster NHK before becoming a Japanese equity broker at what was then Warburgs. She went on to work at SBC and UBS without moving from her desk in Kamiyacho (it was the age of mergers).

After five years in Japan she returned to work in the UK at Paribas. This soon became BNP Paribas. Again, no desk move was required. On leaving the City, Merryn helped The Week magazine with its City pages before becoming the launch editor of MoneyWeek in 2000 and taking on columns first in the Sunday Times and then in 2009 in the Financial Times

Twenty years on, MoneyWeek is the best-selling financial magazine in the UK. Merryn was its Editor in Chief until 2022. She is now a senior columnist at Bloomberg and host of the Merryn Talks Money podcast -  but still writes for Moneyweek monthly. 

Merryn is also is a non executive director of two investment trusts – BlackRock Throgmorton, and the Murray Income Investment Trust.