Inflation in Hong Kong jumped to 7.9 percent in July, a level which is higher than the pre-financial tsunami peak in mid-2008. Inflation has been accelerating in 2011 and the July figures indicate that it has yet to peak. One may expect inflation in Hong Kong to expand further in the coming months.

GDP growth meanwhile shows the opposite trend, however. After a high of 7.5 percent growth year-on-year in the first quarter, the second quarter increased in real terms at 5.1 percent with a quarter-on-quarter decline of 0.5 percent. The steep decline in the GDP trend – and if it continues in the last two quarters – may result in an annual growth rate lower than the expected 5 to 6 percent projected by the SAR government. The high inflation rate will also erode the nominal growth rate, resulting in a much lower real growth rate.

So it appears that Hong Kong is approaching a state of stagflation.

In fact, if we discount the mainland factor, which has contributed more than half of local retail sales and helped to sustain high property and rental prices as well as a belief in the recovery of local stock prices, Hong Kong should have already entered stagflation by now.

Inflation has also hit lower income groups more than the well-off so far. The large increases in food, transport and housing costs have been affecting the lower income groups more because it takes up a larger share of their cost of living.

It is true that the Chinese mainland factor, in particular the huge contribution to retail sales by mainland visitors, has created many jobs in the service sector and is apparently responsible for the low local unemployment rate. However, the increase in employment has mostly been found in low income jobs.

The middle class in Hong Kong appears to be shrinking and along with it net local consumption has also been declining (although there are no precise statistics to confirm it). The minimum wage has helped to alleviate the difficulties of the lower income groups, but the net benefits may not be so large as firms have tried many ways to reduce the increase in salaries and welfare paid to employees.

With 7.9 percent inflation expected to increase in the coming months, the meager benefits of the minimum wage are likely to erode and those on low-pay jobs may have even less actual purchasing power than before.

Food prices on the mainland may fall in the coming months, but it will be difficult to return to the low inflation rate during and immediately after the financial tsunami. Yuan appreciation may take a larger step under international pressure and the mainland's own desire to reduce imported inflation. One could expect a slowdown in the acceleration of imported food price towards the end of the year, but further yuan appreciation would cancel out the effect and the overall imported inflation may not show any signs of slowing down any time soon.

What can the government do to reduce the inflation-inflicted economic difficulties of the lower income groups in Hong Kong?

If the government still believes in the ideological concept of small government and large market, it will not act. The one-off payment of HK$6,000 for adults already approved for distribution by the government is inadequate as compensation for low-income groups compared to the effects of inflation.

Meanwhile the majority of the funds paid out to well-off residents is a waste of precious government money that could have seen much better use for those in need. Housing costs for many lower income families that do not have the benefits of public housing are very hard to bear, especially when rental costs for substandard residential units in old districts have increased even faster than the average inflation rate.

This is a direct result of the slow construction of public housing units and the rapid increase in the number of eligible residents in Hong Kong. The government has not tried to remedy this by speeding up public housing construction and it seems its promise that eligible applicants should not wait more than three years will not be honored.

With economic growth slowing down, Hong Kong will be relying more on the mainland factor and the impact on the employment and economic structures will be more pronounced. Despite the protection offered by the minimum wage, more jobs in Hong Kong will be concentrated in low-pay service jobs, as the only fast growing sector is tourism and retail sales created by the mainland visitor spending.

Without economic diversification, slowing economic growth means the shrinking of other sectors and industries leaving only those supported by the mainland factor as the pillars of the local economy and employment. Hong Kong may be reduced to an economy dependent more and more on the policy support of the central government.

Without a proactive government that prioritizes economic growth and employment creation in its governance efforts, the coming stagflation will put the local economy and society into a very difficult situation that may create politically destabilizing social tensions. Such a scenario is worrisome. The quickening rate of inflation in July has changed my previous modest optimism. Part of the change may come from the lack of any anti-inflation policies on the part of the SAR government, which continues to let inflation accelerate.

The author is head of China Business Centre, Hong Kong Polytechnic University.