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Why Inflation Is Making A Comeback

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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.

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)

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If this is the case, then why are 10-year mortgage deals available at around 5%?

Because the banks will sell them on to your pension fund?

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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.

If output prices from China stop falling, then that is the end of hyper low inflation. No wonder the worlds Central Bankers are getting twitchy trigger fingers.

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If output prices from China stop falling, then that is the end of hyper low inflation.

If output prices from China start rising significantly and some new country can't be found to export deflation to us, then interest rates are going to well over 10%. The only way to stop inflation will be to destroy demand in the West with punitive interest rates.

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If output prices from China start rising significantly and some new country can't be found to export deflation to us, then interest rates are going to well over 10%. The only way to stop inflation will be to destroy demand in the West with punitive interest rates.

Yup! What goes round comes round. That is why it is called an economic 'cycle'.

Eventually demand out strips supply forcing up prices, cutting demand. It is not easy to cut a workers wage, so industry goes looking for the next source of cheap labour (in the hinterland of Cina, perhaps) but it takes time to build the new factories and train the new workers. By which time inflation gets a hold and IR's go up.

Demand is eventually triggered by the next wave of cheap tat. Saw the same thing in the Seventies with cheap imports from Japan followed by high interest rates of the late seventies and eighties.

What goes around comes around. When will we ever learn?

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For another article on this see 'Will China's next big export be inflation?':

http://business.timesonline.co.uk/article/...2140952,00.html

China's progression in the past 20 years to the first rank of global economic powers has occurred at the same time as the crushing of inflation in the main industrialised economies, arguably the greatest economic achievement in half a century.

The two historic facts are probably related. The sudden surge in the supply of goods -- and to some extent services -- produced at low cost in China has helped to keep the lid on price increases around the world. However, when considering this benign equation it is often forgotten that this happy outcome has occurred in large part because of the way in which Beijing has managed its exchange rate.

Ordinarily in international trade, when a country pours lots of goods on to the global market and runs a large trade surplus, as China has, foreign exchange markets would tend to push up the value of that country’s currency. That, in turn, would make those products more expensive in the rest of the world -- a factor that would tend to offset, at least in part, the low-inflation benefits of those cheap exports.

Yet China has kept its exchange rate fixed throughout this period, meaning that those low-cost goods as priced in yuan have stayed low-cost in dollars, pounds and euros.

Even as Chinese costs themselves have risen rapidly -- inflation in the country, even on official estimates, is high -- the increased prices that companies must pay internally have not been fully passed on in the prices of their goods.

If China were to accede to American pressure to revalue (raise the value of) its currency against the dollar, it would lower import costs for China, but would also, of course, produce an immediate and sharp inflationary impulse in the US and the rest of the world.

With oil prices back above $70 a barrel; with a very strong first quarter of economic growth in the US; a spritely and, for the time being, sustained recovery in Japan; some patchy signs of economic progress in Europe; and a still- surging Chinese economy — then global financial markets are already worrying that longdormant inflationary pressures may be stirring.

Consumer prices so far have not jumped higher in most of the world in response to these pressures, but they would surely rise if US import costs were to jump suddenly.

However, China only accounts for around 5% of UK imports -- so higher Chinese prices may be offset by cheaper imports from the US due to a falling dollar.

CIA -- The World Factbook -- United Kingdom:

http://www.cia.gov/cia/publications/factbook/geos/uk.html

Imports - partners:

Germany 13%, US 9.3%, France 7.4%, Netherlands 6.6%, Belgium 4.9%, China 4.3%, Italy 4.3% (2004)

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However, China only accounts for around 5% of UK imports -- so higher Chinese prices may be offset by cheaper imports from the US due to a falling dollar.

I doubt American workers will be knocking out $20 DVD players any time soon. Also, many of those 'US imports' are probably made in China, and many companies have been outsourcing jobs to China which will also push up inflation if Chinese wages rise.

Also, I wonder how those numbers have changed since 2004?

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I doubt American workers will be knocking out $20 DVD players any time soon. Also, many of those 'US imports' are probably made in China, and many companies have been outsourcing jobs to China which will also push up inflation if Chinese wages rise.

Also, I wonder how those numbers have changed since 2004?

And unless you find another country where people are willing to work 20 hours a day, 7 days a week for about 30p a day then you're not going get cheaper goods.

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  • 302 Brexit, House prices and Summer 2020

    1. 1. Including the effects Brexit, where do you think average UK house prices will be relative to now in June 2020?


      • down 5% +
      • down 2.5%
      • Even
      • up 2.5%
      • up 5%



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