Inflationary pressure in Hong Kong is building steadily. The city's inflation rate currently stands at 3.7 percent. But the combination of progressive appreciation in the yuan, the quantitative easing policy in the US, and increases in world food and fuel prices will continue to put upward pressure on inflation.

And the increase in inflation in the city is also being mirrored on the mainland. With Hong Kong being a large importer of agricultural products from the mainland, the inflation rate across the border has traditionally been a good precursor of future price pressures in Hong Kong.

Thus, inflation rates in Hong Kong and the mainland over recent years have tended to move in tandem, with Hong Kong inflation being typically around two-thirds to three quarters the level of the mainland's. With the introduction of a statutory minimum wage in May this year, inflation in the city could surpass that of the mainland.

Furthermore, the zero-interest-rate environment coupled with rising inflation - turning real rates negative - has encouraged people to spend and invest, further fuelling inflation from the demand side. For these reasons, it is possible that inflation in Hong Kong may top 5 percent by the end of this year.

Inflation is thought of as ultimately a monetary phenomenon. An increase in the broad money supply eventually leads to higher inflation. However, due to the pegged exchange rate system, the Hong Kong government is constrained in being able to curb inflation via traditional monetary policy practice, such as raising interest rates.

However, there are a number of administrative measures that could be taken in order to tame rising inflation. For instance, the Hong Kong government is currently manipulating the consumer price index by waiving one-month of public housing rents. This should eventually lower the CPI by as much as 1 percent given that around 40 percent people in the city are currently living in public housing.

This kind of manipulation mechanism is not unique in the world. In 2008 and 2009, the Middle Eastern oil exporting countries (Saudi Arabia, Dubai and Qatar) also performed a similar maneuver in the housing market in order to cool double-digit inflation.

Inflation erodes purchasing power, and thus acts like a tax on individuals. Savers are also being punished given negative real interest rates, while borrowers are benefiting from lower borrowing costs. Investors and asset holders who invest in inflation-protected products will be better off compared to depositors and individuals whose assets are mainly money balances.

In addition, the adverse impact of inflation also tends to vary across income groups. Given the glut of low-skilled workers in Hong Kong, wages are often slow to adjust to rising inflation. Additionally, welfare recipients and low income individuals tend to spend a higher proportion of their income on food. Thus, in the current environment of soaring food prices, a welfare recipient - whose rent is paid by the government whilst receiving HK$3,000 monthly under Comprehensive Social Security Assistance Scheme - will be experiencing inflation closer to 10 percent.

The Hong Kong government is planning to issue an inflation-indexed bond, similar to US Treasury Inflation-Protected Securities, in order to help individuals hedge against inflation. In the current climate, it is expected that inflation-indexed bonds will be in great demand.

If the government can warrant the return, with tax revenues rising in line with inflation, then this scheme would be - on balance - a good thing and should be sustainable. The problem arises when one asks, how does the government hedge against inflation? In addition, if the lion's share of indexed bonds falls into the hand of institutional investors, the scheme would lose its primary purpose.

Moreover, in a deflationary environment, such bonds also become less attractive. Under such scenarios, the cost will ultimately be borne by tax payers.

The author is associate professor in the Department of Economics at The Chinese University of Hong Kong. The opinions expressed here are entirely his own.

(HK Edition 04/05/2011 page3)