Factors affecting inflation in Hong Kong

inSight

15 Nov 2007

Factors affecting inflation in Hong Kong

Inflation in Hong Kong is affected more by domestic demand and property prices than prices of imports.

Readers may have noticed that the headline inflation rate, as measured by, for example, the Composite Consumer Price Index (CCPI), has remained subdued, contrary to their impression of the actual situation as consumers or observers of economic developments in Hong Kong. There is always scepticism over official measurements of inflation. When I was a statistician, I often countered such scepticism by asking those expressing doubts about the official statistics what method they used in coming up with a different measurement and how it compared with the elaborate and internationally accepted method used for the official statistics.

But on this occasion, there is a good explanation for the observed gap between the headline inflation rate and the impression of consumers. The gap is the result of the special government tax-relief measures, particularly the rebate of property rates. In September 2007 while the headline inflation rate, measured by the year-on-year rate of increase in the CCPI, was 1.6%, the underlying inflation rate, after adjusting for the special effect, reached 2.7%. Furthermore, the seasonally adjusted annualised rate of increase over the three months to September reached 3.4%. Consumer prices have indeed been increasing faster than the rate suggested by the headline numbers.

Given the temporary nature of the rates relief measure, we can expect a spike in the headline inflation rate when its temporary statistical effect wears off. Even if the rebate were re-introduced, the spike would only be postponed and the headline inflation rate would still move closer to the underlying inflation rate. The spike, according to our estimates, will be around one percentage point. We expect it to happen in the second quarter of 2008, assuming the rates relief measure is not repeated in the next financial year.

Many factors explain the faster rate of inflation now being experienced in Hong Kong. The main ones are the buoyant economy, indicated by four consecutive years of above-trend economic growth and reflected in strong consumer demand; the tightness of the labour market, shown by the continuing decline in the unemployment rate; a weaker US dollar to which the Hong Kong dollar is linked; continuing appreciation of the renminbi; rising global food prices; and the gradual pass-through of increases in property prices to residential rents. Current indications are that this rising momentum of underlying inflation is likely to continue.

Rapid labour productivity growth is likely to mitigate some of the inflationary pressures. Labour productivity, measured in output per worker, has been increasing by 5.3% year on year on average since the third quarter of 2003, much faster than the 1.4% growth in labour payroll, although with the unemployment rate continuing to fall, the gap is likely to narrow and the suppressing effect on inflation to be reduced. On balance, we therefore expect the underlying inflation rate to move up in the coming months.

It is interesting to look into the relative importance of the many factors in explaining inflation in Hong Kong. Contrary to common perceptions, given that we are very dependent upon imports, particularly food items from the Mainland, imported inflation is much less important than domestic demand pressures in determining inflation in Hong Kong. According to our internal estimates, in the last two decades, fluctuations in foreign prices (in Hong Kong-dollar terms) on average directly explained less than one-third of changes in Hong Kong's CPI inflation, whereas domestic demand (measured by the output gap) and property prices explained more than two-thirds of such changes. The fixed exchange rate of the Hong Kong dollar against the US dollar is therefore not the main factor behind inflationary pressures.


Joseph Yam
15 November 2007

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