Soaring production costs are forcing China to finally start raising prices. For US policymakers and consumers, the shift couldn't come at a worse time.

It looks like the United States has seen the end of an amazing period of below-average inflation and above-average economic growth.

The gradual integration of China into the global economy gave us those good times. And now it looks like the Chinese economy is going to take them away.

For better than 10 years, the U.S. enjoyed the gift of low inflation. From 1993 through 2004, inflation averaged 2.5% a year. That was significantly below the long-term U.S. trend of 3.0% from 1926 through 2008. And it was a welcome relief after the above-trend inflation of 4.8% from 1980 through 1992.

Because of low inflation, U.S. interest rates gradually fell during those 10-plus years. Interest on a 30-year mortgage dropped from 8.14% in 1993 to just 5.81% in 2004. Businesses and consumers borrowed that cheap money, with the former spending it on new plants and equipment and the latter on new cars and second homes.

Economic growth during those years, discounting the gains from inflation (what's called "real" growth) averaged 3.19% a year, even counting the slump in growth after the 2000 stock market plunge. That was a huge half a percentage point higher than 1980-92's average real growth of 2.69%.

Defying conventional economics
From 1993 through 2004, the economy grew faster than average, and we all paid a smaller-than-average inflation tax on everything we bought. Win-win.

Conventional economics says you aren't supposed to get this kind of a free lunch. If growth is higher than average, the economy is also supposed to deliver higher-than-average inflation. Lower-than-average inflation is supposed to be forever linked to lower-than-average growth. The persistence of a win-win economy with above-average growth and below-average inflation was one of the great puzzles of Alan Greenspan's later years at the helm of the Federal Reserve.
The likeliest explanation centers on China. The extra growth came from a global surplus of capital -- from savings from increasingly wealthy developing economies (China) and from the export earnings of oil-producing and low-wage manufacturing countries (Middle East and China again).

Pay as you grow
That capital, available for investment in new factories at low interest rates, fueled the global boom in real economic growth. (This low-cost capital also fueled the technology bubble that burst in 2000 and the real-estate bubble that began to deflate in 2007 -- so maybe conventional economics is correct and there is no such thing as a free lunch.)

The lower-than-expected inflation came from low-wage, low-cost manufacturing countries -- China, India, Vietnam, etc. As more manufacturing (and manufacturing jobs) moved from the U.S., Europe and Japan, these developed economies imported larger quantities of low-cost goods. In addition, manufacturers remaining in the developed economies were able to import cheaper subassemblies and cut the cost of their own products.

Economists have dubbed this the Wal-Mart effect. Low prices at Wal-Mart Stores (WMT, news, msgs) and other big-box discounters had a multiplier effect because low prices at these stores acted to depress competitors' prices.

But now it looks like the process has gone into reverse. China is now increasingly exporting inflation.

A case in point
A look at what's happening with the prices of auto parts will show you what I mean. In 2007, China shipped auto parts worth about $8.5 billion to the U.S. That was a 23% increase from 2006. Worldwide exports climbed to $30 billion in 2007, and global exports of auto parts have climbed at a compound annual rate of 57% from 2003 to 2007.

What's driven that growth? It's pretty simple. Price. U.S., European and Japanese automakers and their suppliers could easily lower their costs by buying some of the parts they used to make at home from Chinese companies at prices 25% to 50% less. For automakers looking to cut costs to survive, that was a huge incentive. In 2006, for example, when Ford Motor (F, news, msgs) needed to find $5 billion in cost savings, an increase in the number of parts purchased from China was a key part of the plan. Ford announced it would use $2.5 billion to $3 billion in parts from China in 2006, up from $1.6 billion to $1.7 billion in 2005.

That rush to outsourcing isn't over. For example, Magna International (MGA, news, msgs), a huge Canadian auto-parts supplier that was General Motors' (GM, news, msgs) supplier of the year in 2007, plans to boost outsourcing to China by 65% in 2008.

But costs are now rising in China. At China's Shougang Group, for example, the cost of producing auto parts climbed by 59% in 2007.

The price pressure on automakers is coming from all directions. The cost of raw materials is soaring. Iron ore prices were up 65% in 2007, and domestic steel prices climbed 35%. In February 2008, Baosteel Group, China's largest steel supplier, raised the price of the cold-rolled steel used for auto-body parts by 17%. Wages are climbing. Labor costs in the most industrialized parts of southeastern China have climbed 50% in the last four years. Logistics and freight costs are up. Companies that have moved to remote parts of China in an effort to find cheaper labor have seen increased costs in getting goods to market over China's sometimes inefficient transportation network.

China is also paying the price of inefficiencies in the global transportation system as demand for shipping has resulted in historic highs for bulk carriers and container vessels.

What's driving the change
Two basic and related trends in the Chinese economy are behind all those pressures. First, the decision of the Beijing government to hold down appreciation in the yuan in order to protect Chinese exports has resulted in a runaway expansion of the money supply. Yes, the yuan has climbed in value against the U.S. dollar by about 20% in three years, but the currency is still extremely undervalued.

To limit the rise in the yuan, which makes Chinese products more expensive to overseas customers, the Chinese central bank has had to buy dollars, but that has had the effect of putting more yuan into circulation. In April, China's money supply grew 16.3%. That's an improvement from April's 17.5% annualized growth but still more than enough to stoke inflation. Inflation in consumer prices hit an annualized 8.5% in April. That's the third straight month with inflation above 8%.

Second, inflation now has its own momentum in China. Workers -- in short supply in many of China's most industrialized areas -- are demanding that wages keep up with inflation and then some. The minimum wage in Shanghai, for example, which went up by 12% in September 2007, climbed an additional 14% in April.

Chinese companies that had eaten these higher costs rather than pass them on to their customers are finally throwing in the towel. Chinese makers of air conditioners, refrigerators and washing machines had not raised prices despite the climb in the cost of steel, but they're now scrambling to see who will raise prices -- and lose market share -- and who will hold prices steady -- and lose profits. So far it looks like white-goods giant Haier Group has beaten back efforts to raise prices for air conditioners but is leading the way with a 5% to 10% increase in the prices of washing machines and refrigerators.

The three largest contract manufacturers of laptop computers -- Taiwan's Quanta Computer, Compal Electronics and Wistron -- have finally brought such customers as Hewlett-Packard (HPQ, news, msgs) and Dell (DELL, news, msgs) to the bargaining table over price increases. Over the past few years those big customers had forced the contract manufacturers to eat rising labor, plastic, copper and component costs at their mainland Chinese factories.

But in May the manufacturers hit the wall. Labor costs in China are up 25%, the manufacturers say, and consumers are just going to have to pay part of that in higher prices for laptop computers.

Because Chinese companies have been so reluctant to raise prices, corporate and individual consumers in the U.S. have only started to see China's newest export, inflation, in the prices they pay in stores. But the effect, while small, is visible. In 2007 the prices of Chinese exports to the U.S. rose 2.4% from 2006. Not very much considering the rise of the yuan against the dollar -- but earthshaking when you consider that the prices of Chinese goods imported into the U.S. have been falling year by year even as the dollar slumped against the Chinese currency.

Higher prices for US consumers
The numbers show us shifting from a period when the constantly falling prices of Chinese import prices were subtracted from U.S. inflation to a time when rising prices of Chinese imports adds to U.S. inflation. With the Federal Reserve already worried that U.S. inflation is too high, the shift couldn't come at a worse time.

And the rising prices of Chinese imports won't help struggling U.S. consumers either. Chinese imports account for just 8% of consumer spending in the U.S., but those imports are disproportionately represented in categories such as toys (80%), shoes (85%) and clothing (40%). The toy industry, for example, projects 5% to 10% price increases by Christmas.

And any price increase on Chinese imports will also hit disproportionately hard at big-box stores such as Wal-Mart. About 70% of the products that Wal-Mart sells come from China.

None of this is exactly good news. U.S. consumers already strapped by the rising costs of gasoline and food don't need to see price increases at Wal-Mart and Costco Wholesale (COST, news, msgs) for clothes, shoes and toys. And the U.S. economy is struggling with its own inflationary burden: Consumer prices climbed at an annual rate of almost 4% in April, if you believe the official numbers.

The Federal Reserve would love to see that number fall back below 3%. The bankers hope a slowing U.S. economy will do the trick by itself, without the central bank raising interest rates. Any increase in rates, of course, raises the odds that the U.S. economy will slip further toward recession and that a new crisis will erupt in the financial markets.

Any gradual increase in inflation caused by China's newest export will make the challenge facing the Federal Reserve just that much tougher.

Buy Middleby (MIDD, news, msgs): Middleby doesn't often disappoint Wall Street, so when it does, I think you have to take advantage of the buying opportunity. On May 8, the company announced earnings of 84 cents a share, 2 cents below the Wall Street consensus, according to Zacks Investment Research.

Middleby's revenue climbed 52% from the first quarter of 2007 but, at $161 million, still fell short of Wall Street projections of $165 million for the quarter. Almost all of the revenue growth in the quarter came from acquisitions.

It's hardly surprising that a company that sells ranges, charbroilers and other food-preparation and beverage-dispensing equipment to the restaurant and food-service industries should stumble as the economy slows. Restaurants, facing their own revenue problems, have cut back on equipment purchases. Rising steel costs haven't helped either.

But Middleby has a history of plugging ahead, come strong or weak economy, with its two-pronged strategy of 1) acquiring smaller competitors in what is still a very fragmented industry and then driving up profit margins at those companies, and 2) pushing out a constant stream of new products that provide customers with substantial savings over older equipment.

Middleby's most recent acquisitions, for example, average gross margins of about 33% while Middleby's average is 40%. About 20% of estimated 2008 sales will come from new products. As of May 20, I'm adding Middleby to Jubak's Picks with a target price of $66 a share by December 2008. (Full disclosure: I own shares of Middleby in my personal portfolio.)

Developments on a past column
"5 financial stocks for the long term": Citigroup (C, news, msgs) has begun to identify the $500 billion in noncore assets that it intends to sell off. And investors who had hoped the bank would concentrate on consumer banking and international expansion are bound to be a bit disappointed.

The bank is looking to sell off its German retail banking business, which has about 3.3 million customers. A leader in the credit card and consumer lending market in Germany, the unit made a profit of more than $500 million in 2007. Wall Street analysts figure that Citigroup could get $6 billion to $8 billion for the business. Watch the deal to see what bank expands into the market that Citigroup is leaving.