ôToday the story is inflation, inflation and inflation,ö says Michala Marcussen, Paris-based strategist and head of economic research at SG Asset Management, with Asian markets such as India and China both the initial sources and victims of changing economic conditions.

She argues that the headlines about high prices in oil and food are only part of a global inflationary trend. Labour markets in emerging markets are the more important story.

Marcussen expects inflationary pressures will gradually lead to the deepening of AsiaÆs capital markets, with its bond markets deepened and its capital accounts opened to foreign investors.

The world has prospered since the 1980s thanks to deregulation, credible central banking policies, free trade and open capital accounts; ChinaÆs accession to the World Trade Organization may have represented the peak of this ôGreat Moderationö, with its commitment creating yet another deflationary shock.

Competition and falling prices of goods and services allowed monetary authorities in North America, Europe and Japan to pursue low (or in JapanÆs case, ultra-low) interest-rate regimes, which are now being blamed for the housing bubble in America and parts of Europe that popped last summer.

Although the collapse of AmericaÆs housing market has received plenty of attention, another important trend has been the ongoing shift in emerging marketsÆ growth models. China, for example, built its role as æworkshop of the worldÆ thanks to the flood of cheap labour out of its villages. This supply continues but gets more difficult to tap as the hinterland moves further from the booming coastal cities.

And China, India and other emerging markets are simultaneously moving up the industrial value chain. Now they face shortages in skilled workers. For both skilled and unskilled labour, incremental wages are rising.

Labour-led inflation, combined with soaring costs in areas such as rice, pork and oil, mean the emerging-market growth story is entering a new, more volatile phase.

ôThis will require better policymaking and the chance to avoid similar mistakes made by the West,ö Marcussen says. ôUnfortunately I donÆt see this is happening, judging from the reaction to the current food crisis.ö

She cites follies in the US and Europe in the early and mid 1970s, when governments increased their meddling in the economy. The Nixon administration, for example, imposed food price controls and wage indexation û policies now widely regarded as a failure. Many agricultural producers are now slapping on export taxes or other protectionist measures to distort the market price of food, water or power.

This will lead to higher borrowing costs, higher inflation and more market volatility, Marcussen predicts. It will also lead more governments to boost spending, both in areas like infrastructure as well as in subsidies and wage increases for civil servants.

Demographics are also driving up labour costs in many Asian countries, as ageing societies reduce the available workforce. This means that in places such as Japan, which has grappled with severe deflation for years, the economic slowdown hasnÆt led to a deterioration in salaries. ôThe irony is that JapanÆs demographics could turn it into a future source of inflation,ö Marcussen says.

Such inflationary pressures will accelerate the recent revaluing of Asian currencies, but also exacerbate the need for a more efficient market structure, better institutions, and open capital accounts. It will also lead Asian policymakers to address income inequality and other aspects of growth, to support æqualitativeÆ or æsustainableÆ growth versus breakneck growth of the past decade.

In the next few years, these inflationary trends will hit developed countries, and Marcussen expects the Federal Reserve will be forced to move short-term interest rates to a more normal, 4-4.5% level in order to deal with inflation. The risk is that it takes too long to do so and lets the inflationary genie out of the bottle, she says.

For investors this future of rising labour costs suggests foreign exchange will become more prominent as an asset class. Over the medium or long term, FX can serve as protection against inflation, as currencies gradually adjust to reflect purchasing power parity. Marcussen also believes inflation-linked bonds will become more attractive. But commodities are not a hedge against inflation; while they may have their own structural story that supports rising prices, they remain separate from wage inflation trends.

For Asia, the rise of spending and the deterioration of fiscal and trade account balances will likely lead to more borrowing. First governments will need to deepen their own local bond markets, which will pave the way for more varied corporate issuance. Demographics and the rise of sovereign wealth funds will also create more investor demand for deep and liquid Asian bond markets. But putting such structures on solid ground ultimately means opening capital accounts to foreign investors, Marcussen says.