Smallest decline in prices in seven months signals that inflation may return by the middle of next year Hong Kong entered its sixth year of deflation, with consumer prices falling again last month. But the decline was the smallest in seven months, giving hope to those expecting a return to inflation next year. The composite consumer price index (CPI), which measures the cost of a basket of commonly used goods and services, fell 2.4 per cent last month compared to the same period last year. It was the 61st consecutive month of deflation but the slowest rate of decline since April, when the index fell 1.8 per cent. The composite index, the most widely used gauge of deflation, dropped 2.6 per cent in the first 11 months of the year. Hong Kong has been in deflationary mode since November 1998, when prices started falling because of the Asian financial crisis. But the government and analysts predict a return to inflation perhaps as early as the middle of next year as the economy gains strength and property prices recover. 'You can say that we're coming to the tail-end of deflation but it will drag on this year. By the second or third quarter of next year, it will probably end,' said Li Kui-wai, associate professor of economics and finance at City University. Several recent economic indicators have shown there is plenty of strength in the economy. Unemployment fell half a percentage point to 7.5 per cent last month, while third-quarter gross domestic product expanded 4 per cent over last year, a rate that is expected to continue into the final three months. Retail sales from August to October saw year-on-year growth, the first time in two years, aside from the Lunar New Year months. The flood of high-spending mainland visitors is helping to buoy the retail sector. 'We have seen some improvement in retail sales and the downtrend of retail prices is getting narrower. That means most retailers are regaining pricing power' which will help get Hong Kong out of its deflationary rut, said Henry Tsoi Wing-fai, a senior economist at Hang Seng Bank. Most promisingly, property prices seem to be rebounding, and have risen 15 per cent since the end of the Sars outbreak in the second quarter, said Buggle Lau Ka-fai, chief property analyst at Midland Realty. Public and private rent and other housing costs account for about 30 per cent of the CPI, the largest portion. Hong Kong should also benefit from a return to inflation on the mainland, where prices rose 3 per cent last month, the biggest yearly rise since November 1997. Grace Ng, an economist at Goldman Sachs, said that 'should directly feed through to Hong Kong's food and tradable goods prices'. Food accounts for about 26 per cent of the CPI, the second largest portion. The weaker US dollar will make goods imported from elsewhere more expensive, but the effect will be minor, analysts say. Last month, higher clothing and shoe prices were the main drivers behind the smaller decrease in the CPI. Higher charges for package tours and jewellery prices also played a part, as did a smaller drop in the cost of restaurant meals, the government said yesterday. The CPI decline 'occurred as some of the local retailers reduced price discounts and other concessions on their goods and services, and as some others adjusted the respective prices modestly upward, amidst the pickup in local consumer spending and surge in inbound tourism in recent months', it said. Housing costs had the biggest drop last month, falling 5.6 per cent over last year, followed by durable goods, which fell 5.4 per cent.