Global inflation fear spreads

Inflation worries are now gripping global markets, after figures showed that the Chinese economy grew at a faster than expected clip in the final months of 2010, while a key manufacturing index pointed to rising cost pressures in the United States.

Commodity prices have soared in recent months, after the US Federal Reserve's decision to launch an additional $US600 bond buying program, known as QE2.  Many emerging countries complain that this policy – which has resulted in steep rises in food and fuel prices – has left them battling severe domestic inflationary problems, as well as swelling asset price bubbles.

Official figures showed the Chinese economy expanded at an annual rate of 9.8 per cent in the final quarter of 2010, stoking fears that Beijing would be forced to raise interest rates to subdue an overheating economy.

Although consumer price inflation eased to 4.6 per cent in December, this was seen as a temporary decline. Price pressures – particularly for politically sensitive food prices – are continuing to mount.

Beijing has raised interest rates twice, and ordered banks to increase the level of reserves they hold with the central bank, as well as imposing price controls on some staple goods in an effort to combat rising inflation.

But markets are worried that Beijing will ramp up its tightening measures in order to combat inflation, and that this could cause economic activity to slow sharply.

At the same time, the closely-watched Philadelphia Federal Reserve manufacturing index pointed to mounting US price pressures. According to the index, 54 per cent of the firms surveyed reported they faced higher prices for inputs, compared with 52 per cent the previous month. The index of prices paid increased by 6 points in January, bringing its total rise to 42 points over the past four months.

The index also showed that businesses were having some success in passing these higher costs on to their customers, with 26 per cent of firms reporting increases in prices, and 9 per cent reporting decreases. The index of prices received rose by 8 points in the month, its second consecutive rise.

Concerns that global inflationary pressures are rising have also pushed US interest rates higher, with the yield on the benchmark 10-year bond climbing to 3.46 per cent, the highest level since January 9.

But while bond markets may fear the reappearance of inflation, US workers are unlikely to be able to demand higher wages because unemployment has remained stubbornly high. As a result, US inflation is likely to remain subdued.

This means that US households, which are also facing steep increases in their food and energy bills, will have little choice but to cut back on how much food and fuel they consume, or to cut back their spending in other areas in order to compensate for higher food and fuel costs.

At the same time, the rise in long-term interest rates in the wake of the US central bank's bond-buying program has left consumers, businesses as well as local and state governments facing higher borrowing costs. And higher interest rates have made banks more wary about lending to debt-laden consumers.

The US Fed had hoped that its bond buying program would boost share prices, and that consumers – feeling increasingly wealthy – would spend more. Instead, inflation worries have pushed up interest rates, and left US consumers and businesses shouldering an additional burden.