Inflation in perspective
The concern is not so much about core CPI rising to a multi-year high because core CPI inflation is still low. But it is disturbing to see core CPI inflation rise above the headline CPI. Together with the PPI strength sustained at 5% YoY, investors are right to worry about an inflation scare leading to monetary tightening. Chinese bond yields have indeed been rising since October in response to this concern.
However, the current macroeconomic dynamics do not point to monetary tightening in the coming year. The fact that PPI inflation has not trickled down to CPI inflation suggests that there is an inherent deflationary drag in the economy due to a stock of excess capacity and a flow of structural reforms to cure this stock problem.
Unless CPI inflation surprises on the upside and pushes above the 3.0% official target persistently and the US Fed raises rates by more than market expectation, the PBoC will likely keep a neutral policy stance in the coming year to ensure sufficient liquidity for supporting Beijing’s moderate growth target.
Forces restraining inflation
There are headwinds to growth that will constrain demand (including for services) from pushing up inflation higher-than-expected. They include a slowing housing market, scaling back of fiscal stimulus, intensifying deleveraging and structural reform efforts (including tightening up of environment controls), a lack of “animal spirits” and easing export growth. Consumption indicators are showing moderating demand already. Meanwhile, the recovery of PPI inflation has boosted nominal GDP and industrial profit growth, creating a benign backdrop for Chinese equities, ceteris paribus.
The policy perspective
There is also a policy angle to consider. In many developed economies, core CPI inflation is more important than the headline CPI because their central banks tend to follow/target core CPI. However, the PBoC’s policy reaction function is different from the developed market central banks’ practice.
The PBoC does not pursue an inflation-targeting monetary policy model based on core inflation behaviour. It follows multiple targets, including inflation, economic growth, financial stability, structural reforms and employment. Crucially, these targets and their weights in the PBoC’s policy reaction function change from time to time. The PBoC has never had a rule-based policy of tracking/targeting core CPI. It always refers to overall CPI and sets a target on overall CPI inflation (which is 3%); and 30% of CPI is food.
What’s driving service price inflation?
It is true that core inflation has been rising due to rising service prices, which are driven mainly by healthcare, education & entertainment and residential costs including rents, renovation, utilities etc. Soaring healthcare & medical service prices are mainly due to the reform of China’s medial system since mid-2016 when Beijing started abolishing the price caps on most medicine and drugs and allowing private hospitals to charge their services at market-determined prices (but public hospital services are still subject to government price controls). The pace of medicare price inflation should moderate once the reform is implemented across the country (so that the low-based effect will fall out of comparison).
Residential costs inflation will also likely come down due to the cooling of the property sector. Education and entertainment costs inflation has already rolled over as slowing growth momentum, deleveraging and structural reforms drag on entertainment and discretionary expenses. Therefore, core CPI inflation may not rise much further.
In China, rising core CPI matters only when it pushes up overall CPI persistently. The core CPI concept itself does not determine Chinese monetary policy at this stage. Evidence shows that the PBoC only hikes benchmark interest rates when overall CPI is high; and in many occasions when overall CPI was high, food price was high too.
So we should be monitoring food-price behaviour. If it picks up and couples with non-food and PPI inflation to boost overall CPI, this may prompt monetary tightening. But the growth headwinds will likely provide an offset to these forces and overall CPI is expected to rise by 2.2% (my forecast) next year. This will still be lower than the official 3% target. It is too early to conclude that rising core CPI inflation would prompt monetary tightening soon.Download to read more