Is the China Syndrome over?

A few thoughts on inflation. Read original article by Evan Davis

For the last few years, the biggest risk to the strong performance of UK economy has been inflation.

It has seemed fairly tame, and even-higher oil prices in recent years did push it worryingly high.

But the risk has long been that we would discover that underneath our strong economy, was brewing some hidden inflationary pressure.

If that emerged, it would imply that some of our recent economic success had been built on shaky foundations: it would mean that interest rates had perhaps been "too low", that the borrowing we have done on the back of low interest rates was less affordable than we thought, that the house prices we have paid on the back of easy borrowing are unsustainably high, and that any sense of consumer wealth deriving from higher house prices is a mere illusion.

Indeed, for quite a while, one has been able to imagine the benign conditions of the last few years unwinding if inflation materialised. And that's why economists have been watching it so closely. It is not just about the discomfort of higher prices.

Well, has this inflationary pressure now materialised, or is today's 3.1 per cent rate just a blip?

Certainly it could be a blip as inflation is volatile at the moment, largely as a result of energy price swings. We can soon expect the measured inflation rate to fall as last year's energy price rises drop out of the twelve month inflation rate. And it may fall further as this year's energy price rises push the rate down. And then we can expect it to rise again in a years time, when this year's falls also drop out of the twelve month rate.

So we have to see through that volatility and ask where inflation will settle. That should be well below three percent, but there is still room for concern.

It all comes down to the China effect. In recent years, our economy has been dependent on deflating imported goods prices. To some extent, we've been able to enjoy simultaneous fast domestic growth, strong consumer spending and low inflation, because the prices of manufactured goods have been falling each year.

If the flow of cheap imports dries up, either because the Chinese export prices rise or because our exchange rate falls, then we have to adjust the domestic economy to slower growth and restrained consumer spending.

Today's figures show some worrying signs that manufactured goods prices are picking up. Furniture, toys and games, clothes and textiles all get an honourable mention in the statistical press release, as exerting upward pressure on prices.

One theory is these are going up in price now, as we've reach the end of the gains to be derived from out-sourcing our factories. When there are no more factories to send abroad, there are no more cost-savings to be found in manufactured goods prices.

An alternative theory is that these price rises were merely a pre-Easter one-off, as shops raised prices in anticipation of cutting them again to boast of special offers over the holiday weekend. On that view, they'll unwind in the figure next month.

It's too early to be definitive on whether or not it's time to call an end to the era of ever-cheaper imports, but its certainly a factor to watch.

The other factor to watch is the exchange rate. It has been relatively high, and in recent days strengthening against the dollar. As most Chinese imports are priced in dollars, they are going to get cheaper not more expensive when converted into pounds. But unless the pound rises forever against the dollar - which is unlikely - the exchange rate provides just temporary shelter against import price rises. Don't learn to rely on it.

My own view is that the lesson from the last few months' news on inflation is that if we know we are relying on some potentially temporary factors in keeping our inflation rate down, we might want to be more cautious in economic policy.

Instead of running the economy at a fast speed with inflation pushing at the top end of the tolerable range, you would prefer to have a safety margin, so that if the worst price risks do materialise, there's less of an adjustment to be made.