Fear of inflation? Certainly not in China
With the increasing optimism about economic recovery, the market starts to be concerned about rising inflation risk, especially in the US where US long-term Treasury yields been rising rapidly. While we also expect inflation to rise in China thanks to the continued economic recovery, the upside risk is clearly more moderate. There are a few reasons for this.
First, China’s inflation has been moving structurally lower. From 2012 to 2016, China’s core inflation rate (excluding food and energy) has been moving within the range of 1% to 2% (Chart 1). It slightly surpassed 2% during 2017 and early 2018, but then moved all the way downward to 1.5% in January 2020, which was before the outbreak of the Covid-19. In other words, the Covid-19 outbreak accelerated, but not initiated, inflation’s downward trend. The situation is likely to continue on the back of the long-term structural factors, including population aging, rapid digitalization of the economy and a slower wage growth since the peak of the growth rate in 2007.
Second, from a cyclical perspective, demand plummeted with Covid-19, which brought the core CPI to increase by as low as 0.5% during most of the second half of 2020. Stronger demand in 2021 will push prices up, especially in services, but its recovery also depends on the evolvement of the Covid-19 situation. For manufactured goods, demand has been recovering slowly compared with supply (See: Our earlier paper on consumption). The industrial inventory has been rising steadily since May 2020 (Chart 2), indicating that industrial firms in China have been preparing for a higher demand.
Thirdly, the PBoC is expected to continue to hold a cautious stance. Since May 2020, as the pandemic was controlled, the PBoC’s monetary policy has been much less lax compared to the Fed and the ECB, as shown by the rise in 3-month SHIBOR after Q2 2020. In the latest China’s government report, the official attitude in 2021 remains conservative, which is to “keep our prudent monetary policy flexible and targeted and at a reasonable and appropriate level”. As such, inflationary pressures should be easier to tame.
Fourth, food prices, which is key component of headline inflation, have moved down quickly from the high level since the beginning of 2020. The dramatic decline in the headline year-on-year CPI growth rate in early 2021 continued to reflect the retreat of food price.
All in all, we expect China’s inflation rate to grow only moderately in 2021. Headline inflation rate may be even lower than the 3% target set by the government during the Two Sessions. This is in line with general trends since 2012 and it reflects China’s massive production capacity which generally outpaces demand, the more so structurally based on an aging population. Short term inflation dynamics are also more favorable than in the US given the PBoC’s cautious stance (See: Our analysis of the 2021 government report).