The Inflation Dragon Is Alive and Well

08/28/2008 12:00 am EST

Focus: MARKETS

Jim Jubak

Founder and Editor, JubakPicks.com

Jim Jubak, senior markets editor for MSN Money, says the big danger of inflation isn’t in the US but in Asia.

At the core of the current wave of volatility are investor worries that growth is slowing in the Asian economies, which have been driving the global economy forward since the US dropped into low gear in the fourth quarter of 2007.

Growth in China slowed to an annual rate of 10.1% in the second quarter of 2008 from 11.9% in 2007. Economists are predicting growth will slow even more in the rest of 2008 and in 2009.

The pattern is similar in other Asian economies big and small. India, where gross domestic product grew 9.1% in the fiscal year that ended in March, will see growth of 7.1% this fiscal year, according to Morgan Stanley.

Soaring inflation in Asia seems to be at the root of the slowdown, and the damage to Asia's economies is largely self-inflicted.

China, for example, has been waging a battle against inflation since 2007. The People's Bank of China raised interest rates five times in 2007 to a one-year lending rate of 7.29%, the highest official rate since 1998. Inflation climbed to an 11-year high of 8.7% in February before dropping to 7.7% in May and then to 6.3% in July. Of course, fighting inflation also slowed the economy.

India has been waging an even more aggressive battle. The Reserve Bank of India, the country's central bank, raised its key interest rate to a seven-year high of 9% at the end of July. It's no coincidence that at the same time the bank raised rates, it cut its forecast for economic growth to 8% from 8.5%.

Lower economic growth leads to fewer jobs and higher unemployment that can threaten even a regime as entrenched as the one in Beijing. So, it should be no surprise that China's government has begun to signal an end to the emphasis on fighting inflation and a shift back towards policies that promote higher growth.

China's apparent turnaround on inflation is likely to have wide influence across Asia. It will be hard to hold the line on inflation in Jakarta or Manila or Hanoi when the leaders of the most successful economy in Asia are saying go for the growth.

We're seeing the beginning of a shift away from the fight against inflation that has contributed to a slowdown in economic growth in Asia back toward more growth-at-any-cost policies in the region. In the short run, that will act to stabilize prices for most commodities near current levels.

In the long run, the shift away from fighting inflation and toward growth at any cost is going to accelerate global inflation. That means the next wave of inflation will begin from a higher base rate. A move back towards growth in Asia at this time almost guarantees that global inflation will accelerate to dangerous levels in the next few years. In that environment, you want to own commodity stocks and other inflation hedges.

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