China: Acceleration in Inflation Should Prove Temporary

Inflation in January accelerated markedly from 4.1% y/y to 4.5% y/y, but this appears to be solely due to seasonal distortions from the Chinese New Year holiday. 

A continued decline in producer price inflation and subdued core inflation
suggest that the downward trend in inflation remains intact. Hence, the
acceleration in inflation should prove temporary and we still expect inflation to drop below 3.5% y/y by mid-2012.

Nevertheless, the unexpected large increase in inflation in January will be
another argument for easing monetary and fiscal policy cautiously. We expect People’s Bank of China (PBoC) to cut the reserve requirement by 150bp in H1 12, but there is an increasing risk that monetary policy will be eased less.

Details

Consumer price inflation in January accelerated to 4.5% y/y (Cons: 4.0% y/y, Danske Bank: 4.2% y/y) from 4.1% y/y in December. This was not a surprise to us, but it was a bit more than expected. We had for some time argued that inflation was poised to temporary accelerate in early 2012 due to the seasonal distortions from an early Chinese New Year holiday (CNYH) this year. CNYH this year started 22 January compared to 2 February last year. As food prices tend to increase substantially in connection with this holiday, the year-on-year inflation rate is higher in January and lower in February.

The increase was indeed largely driven by higher food prices. In January food price inflation jumped from 9.1% y/y to 10.5% y/y. That said, our measure of core inflation edged slightly higher as well from 2.0% y/y to 2.1% y/y. However, the overall picture remains that core inflation has eased substantially compared with particularly H1 2011.

Over the past three months our measure of core inflation has only increased 0.4% 3m AR, which is markedly lower than the 3% 3m AR pace in H1 2011.  
Producer price inflation in January eased to 0.7% y/y (Cons: 0.8% y/y) from 1.7% y/y in December. As producer prices are less distorted by the seasonal impact from CNYH it probably gives a truer picture of the underlying inflationary pressure than today’s CPI.

That said, on a monthly basis producer prices are no longer declining (see chart) and in line with recent manufacturing PMIs this suggests that growth has started to improve in early 2012.

Assessment & Outlook

In our view the acceleration in inflation in January should prove temporary. We expect inflation to drop below 4% y/y in the coming months and we still expect inflation to decline below 3.5% y/y by mid-2012. That said, today’s unexpected large acceleration in inflation will be an additional argument for PBoC to only ease monetary policy cautiously. We expect PBoC to cut the reserve requirement by another 150bp in H1 2012, but to leave the leading interest rates unchanged. Admittedly, PBoC has so far been more reluctant than expected to cut the reserve requirement, suggesting that the main risk is that the monetary policy will be eased less than expected.