China Economy:Does higher inflation warrant policy attention?

Fundamentals: January’s PPI was up by 6.9% YoY, higher than the 5.5% YoY in December. Likewise, CPI rose by 2.5% YoY, up from 2.1% YoY in December. Both were higher than Bloomberg consensus polls, at 6.5% and 2.4% respectively. Price pressure has been building in recent months, especially in energy and natural resources. For January, the PPI acceleration was mainly driven by commodity prices. Coal, natural gas and ferrous metal prices rose by 38.4%, 58.5% and 23.7%YoY, respectively. In addition, the price comparisons were from a low base.

    We believe seasonal factors may have played a major role in the rise in CPI. Both food and non-food prices surged temporarily during the Lunar New Year, which fell in January 2017, compared with February in 2016. Food prices were up by 2.7%YoY, led by meat and fruit prices, while prices for packaged tours jumped by 9.9%YoY. Stripping out these seasonal factors, we believe that underlying CPI was only around 2.2-2.3% in January. As such, we expect February CPI to fall to around 2.0%.

    The key question is to what extent the price acceleration was driven by demand factors rather than other factors, and whether it warrants policy attention. Activity indicators including industrial production, FAI and retail sales do not make a convincing argument that it was demand that increased prices, in our view. On the other hand, as the government has taken steps to curb low-quality imports to control air pollution, domestic energy prices are now experiencing cost-driven pressure. In addition, the PBOC has probably created too much new liquidity especially via short-and medium-term lending facilities. This liquidity was created to cope with money outflows. But some of the excess liquidity has gone into speculative areas of the economy.

    We believe it is better for the PBOC to leave things unchanged if pricing pressure is not driven by demand factors. The only reason for the PBOC to tighten, in our view, is to make sure excess liquidity will not lead to undue currency pressure. To a large extent, we believe the currency is already under such pressure because of outflows.

    In fact, the PBOC has started to signal a slight tightening bias. The rates for short-and medium-term lending facilities and repos have been guided slightly higher in the past few weeks. The PBOC also suspended open market operations for 6 days after the Lunar New Year and reopened only to withdraw liquidity from the market. In our 2017 base-case outlook, we see two-way risks for monetary policy -policy direction will depend on flows as well as inflation trends (see our 2017 Macro Outlook). At this point, these trends do not support a case for a textbook tightening via interest-rate and/or RRR hikes. If the PBOC tightens significantly, say 2-3 rate hikes in a year, the probability of domestic debt deflation (scenario 1 in our base case) would rise from the current 25%.