Why inflation isn't just a problem in the UK

Whilst everyone is currently blaming the Bank of England for creating the UK's inflation problem by keeping interest rates too low, we should at least be thankful that we can set our own rates - unlike our nearest neighbour.

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The big economic story of this week, was of course, the massive jump in inflation, which triggered Mervyn Kings first letter to Gordon Brown in 10 years.

(If you want to read the letter and the Chancellor's reply in their full unalloyed glory, by the way, just click here: https://www.bankofengland.co.uk/publications/news/2007/044.htm)

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Suddenly all the pundits have started talking about how the Bank has kept interest rates too low for too long, and that this inflationary burst was inevitable (The Times writer Graham Searjeant wrote a particularly good piece in this vein - if you missed it, it's well worth tracking it down on their website).

Of course, this is something we've been saying for years, though it's nice to everyone catching up, even if its a bit late now.

But slack monetary policy is far from being a problem exclusive to the UK, as yesterdays China-induced tremors in the market showed

A shiver went through global stock markets briefly yesterday, as China's economic growth once again stormed in ahead of expectations, at 11.1% in the first quarter, leading premier Wen Jiabao to announce plans for a further crackdown on lending.

The Shanghai Shenzhen index fell nearly 5%. Mr Jiabao said: "Loan growth is too fast." Inflation is now at 3.3%, the fastest rate in two years, and money is still being piled into building industrial infrastructure that no one really needs. Meanwhile, millions of Chinese are opening trading accounts and diving into the stock market, as a rampant case of genuine casino capitalism overtakes the populace.

As Damian Reece says in The Telegraph: "You don't have to belong to the Austrian School of Economics to know that mad levels of investment, especially when orchestrated by commissars for political purposes, invariably end badly."

Part of the problem is that the Chinese currency, the yuan, remains artificially cheap. All the money flowing into the country is fuelling the boom.

Reece suggests that the regime should "bite the bullet now" on yuan revaluation. Of course, as Reece acknowledges, this would lead to carnage in the countryside as farmers would go bankrupt in the face of cheap grain imports - "it is far from clear that the Chinese Communist Party could survive such an event."

This is probably the reason that the government is trying to find other ways to slow the damaging growth in its investment bubble, such as tightening lending requirements - but as our own Bank of England has found out, if you keep trying to put off the tough choices until tomorrow, the problem youre attempting to escape just gets larger and larger.

Of course, at least in the UK, and even in China, they have a choice. Some countries don't even have the option of setting their own rates - and Irelands population is on the verge of finding out just how vulnerable that can leave you.

The country's central bank (effectively now a branch of the European Central Bank) has warned that the outlook for growth is much less cheery than its bosses over at the ECB think. And it's little wonder they disagree - while Germans might be enjoying something of an economic revival, the massively over-indebted, mortgaged-to-the-hilt Irish are looking at inexorably rising interest rates with a sense of disbelief.

Personal debt in Ireland, at 190% per head, is the highest in the developed world, as bank lending and house prices have soared. "The reason Ireland (and Spain) have seen such fast credit growth is that interest rates have been too low," Richard Fox of Fitch Ratings tells The Telegraph. "It's the consequence of the one-size-fits-all policy."

The trouble for Ireland and its "Club Med" peers is that when the European Central Bank looks at the correct interest rate for the region, it's much more interested in what matters for Germany, than for the smaller members of the Eurozone. And right now, Germany's doing rather well, thank you very much. So it looks like there'll be no relief coming from that direction.

Of course, controlling your own interest rate isn't much good if you don't make use of it. MoneyWeek regular James Ferguson points out that even while the press are now gingerly suggesting that we might see a 6% interest rate, the truth is that the last time inflation was this high, the UK base rate was closer to 7% to 7.5%. Could it go that high again? It looks like we're going to find out.

James runs his own investment advisory service, Model Investor you can read more about it in an email that will be landing in your inbox at some point tomorrow keep an eye out for it.

Turning to the stock markets

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In London, the FTSE 100 index of leading shares closed 8 points lower, at 6,440, yesterday. Insurer Prudential and pharma GlaxoSmithKline were Thursday's best performers, whilst heavyweight miners - including Antofagasta and Vedanta Resources - weighed on the downside. For a full market report, see: London market close .

On the Continent, the Paris CAC-40 ended the day 6 points lower, at 5,829. In Frankfurt, the DAX-30 was dragged lower by the likes of RWE and Lufthansa to close 39 points lower, at 7,242, although off an earlier low of 7,155.

Across the Atlantic, stocks closed mixed as the pharmaceutical and biotech sectors made gains whilst oil majors and metals miners fell. The Dow Jones industrial index recovered from a morning slump to achieve a new record closing high of 12,808, a 4-point gain. The Nasdaq lost 5 points, ending the day at 2,505. And the S&P 500 lost one point to close at 1,470.

In Asia, buyers cautiously returned to the Nikkei following yesterday's losses, helping the Tokyo index to a close of 17,452, an 80-point gain. In Hong Kong, the Hang Seng added 234 points to close at 20,534.

Crude oil was 52c higher at $62.35 this morning, and Brent spot had edged up to $65.79 in London.

Spot gold lurched between an 11-month high of $691.50 and a low of $678.70 yesterday, and was trading at $684.70 this morning. Silver had climbed to $13.73

And in London this morning, private equity group Kohlberg Kravis Roberts and billionaire Stefano Pessina raised their joint bid for Nottingham-based chemist Alliance Boots to £10.6bn. KKR and Pessina's offer of 1,090p a share is intended to thwart a 1,085p a share bid from rival Guy Hands of Terra Firma Capital Partners. Shares in Alliance Boots had risen by as much as 6.2% in early trading.

And our two recommended articles for today...

The secret of success in the UK's shrinking equity market

- Private equity buyouts, share buy-backs and foreign takeovers saw the UK equity market shrink by a record £64bn last year. However, choose the right investments for these new conditions and you could see your profits grow nicely. For Brian Durrant's tips on investing in equities (and another market set to benefit from equity market shrinkage), see: The secret of success in the UK's shrinking equity market

Why Stephen Roach doubts the IMF's optimism

- The IMF's latest forecast for global economic growth is the 'single most optimistic' economist Stephen Roach has ever seen. But he has some reservations about this rosy scenario. For his analysis of the figures, including the two major risks the IMF failed to take adequate note of, click here: Why Stephen Roach doubts the IMF's optimism

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.