Hong Kong's consumer price inflation (CPI) remained benign at 1.9% in the first 11 months of 2007. The low headline CPI reading, however, is largely due to factors that are temporary in nature, that is, the government's one-off waiver of public housing rent and property rates. The October and November consumer prices climbed to a nine-year high of 3.2% yoy and 3.4% respectively immediately after the rates concession ended. Removing the noises, housing rentals would have gone up 4.4% in the first 11 months, taking the overall inflation rate to 4.0%, instead of the reported figure of 1.9%.

Looking ahead, inflation risk is rising. Food prices have been surging and are unlikely to stabilize in the near term due to tight supply, and price pressures are also building up in the domestic economy as well as in the external environment.

Strong Domestic Demand is the Primary Cause

Underpinned by the buoyant domestic demand, or more precisely the robust domestic consumption spending, the Hong Kong economy has registered above-trend growth for 16 consecutive quarters. The protracted period of fast growth has created pressure on output capacity, which is commonly reflected in the tightness of the labour market. When businesses pay more for labor, they are more likely to pass on the higher costs to the consumer.

Wage growth tends to move inversely with the unemployment rate. While wages hardly grew in the early half of the decade as the unemployment rate remained at historically high levels, the trends seem to be reversing. Wage growth has been rebounding at a 2% pace following improvement in labour market conditions. The pace of wage growth is likely to accelerate given the latest full employment situation in Hong Kong.

The unemployment rate fell to 3.4% in December and demand for workers remains strong. According to the latest surveys conducted by the Hong Kong Institute of Human Resources Management, staff turnover rate hit record highs in 2Q2007 and 97% of companies offered pay increase to their staff and no company opted for pay cut. These numbers imply that the strains from persistent rapid economic growth will become more apparent in the near future.

Rising wages are not necessary inflationary, if labour productivity gains are fast enough to cushion the cost increase. Labour productivity has been growing at over 5% per year in the last few years, much higher than the 1% average growth in nominal wages. The 4% plus productivity-wage gap played an important role in mitigating the inflationary pressure. Nevertheless, the gap is narrowing with payroll growth likely to catch up notably.

While labour costs are on the rise, interest costs are likely to ease further.

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