China: Consumer inflation to remain benign despite surging commodity prices
Chinese inflation figures for May brought both upside and downside surprises. PPI inflation came in at 9.0% year-over-year (y-o-y), up from 6.8% in April and continued to beat expectations. However, CPI inflation in May was lower than expected, at 1.3% y-o-y, only moderately higher than the previous month’s reading (0.9%). In our view, the unique pattern of economic recovery in China will likely limit the pass-through of inflation pressure from commodity prices to domestic consumer prices. However, the same may not be true for Chinese exports. In other words, China will likely pass the rising commodity prices to customers in the rest of the world through exports.
Chinese PPI surged again in May but may have formed a peak
China’s PPI rose by 9.0% in May, the highest rate since September 2008 and beating the consensus and our own forecasts. While the magnitude of the rise in Chinese PPI is a surprise, the direction of the move is not, which is well indicated by the changes in commodity prices earlier, given the strong correlation between global commodity prices and industrial inflation in China.
Regarding PPI, two observations are worth highlighting.
First, we suspect that China’s PPI inflation may have peaked (in y-o-y terms) in May, given the dynamics of global commodity prices, especially prices for crude oil. Historically, the y-o-y changes in global commodity prices have led the Chinese PPI by roughly one month. While crude oil prices in absolute terms continue to stay elevated for the time being, from a y-o-y comparison perspective, the changes may have peaked, along with the prices of some other major commodities such as base metals. This is indicated by the Bloomberg commodity index, which rose by 46.1% y-o-y in May, down from 48.4% in April.
Limited pass-through from upstream to downstream
Second, while PPI inflation rose strongly in May, the price pressure is highly uneven along the value chain. The upstream sectors (e.g. mining and materials) show the strongest rise in their out-of-factory prices, but the downstream sectors’ price hikes are much more muted (e.g. for consumer goods). In May, the PPI for industrial goods rose by 12.0% y-o-y, while that for consumer goods rose by only 0.5%. This indicates very weak transmission of inflation pressure from the upstream sectors to the downstream sectors.
While this phenomenon has been present in China since 2012, the unique pattern of China’s economic recovery from the pandemic has likely reinforced it. In some advanced economies (e.g., the United States), economic recovery is characterised by a quick rebound in consumer demand (helped by unprecedented fiscal stimulus that led to a rise in household disposable income during the crisis), but was met with supply-side bottlenecks, which jointly led to upward price pressures. In contrast, due to its early successful control of the coronavirus, China’s production capacity has already been fully back on and there are hardly any supply-side bottlenecks. What’s lagging now is the slowly recovering domestic consumer demand, which has not enjoyed the same kind of government assistance as their counterparts in the advanced economies. Hence, it’s quite difficult for consumer goods manufacturers to pass on the price increase from raw materials to their domestic customers.
Given the weak price transmission within PPIs, it’s no surprise that China’s core inflation, which came in at 0.9% in May, does not show strong upward pressure either so far. China’s headline inflation in May came in at 1.3%, which is below our own and the consensus expectations. While the much higher fuel prices (+21.3%) boosted headline inflation, the latter was weighed by low food inflation as pork prices dropped even further in May (-23.8%). Services inflation continued to improve in May (+0.9%), but it was still at a low level. Given the downside surprise for CPI in the new data release, we decided to revise down our Chinese headline inflation forecast to 1.2% from 1.7% previously, while keeping our 2021 core inflation forecast unchanged for the time being at 1.4% .
But China may export inflation to the rest of the world
While the domestic transmission between China’s PPI to CPI seems to be quite muted, the link between Chinese PPI and Chinese export prices is much stronger, especially for intermediary goods. Changes in PPI of industrial goods usually lead Chinese export prices by three months. This means the elevated PPI inflation in China probably is (and will likely continue to be) passed on to the rest of the world through exports in the months to come.
Looking forward, we expect China’s core inflation and headline inflation to move moderately higher in the remainder of 2021, but both should stay well below the policy makers’ target. As a result, we do not expect inflation to have any material impact on the PBoC’s monetary policy stance in 2021, which has already had a tightening bias given its emphasis on policy normalisation.
For the real economy, the divergence in upstream and downstream prices will likely hurt downstream companies’ profit margins, which is something that the policy makers are apparently worried about. The Chinese government recently implemented some policy measures that attempt to curb the further rise in domestic prices for some raw materials. These measures range from boosting domestic supply of some materials (such as certain steel products) to discouraging speculation in the spot and futures markets. These efforts have led to price corrections for some commodities in China. Whether these efforts can have a long-lasting impact remains to be seen.