Inflation Outlook in 2010: A Supply-Side Perspective

November 03, 2009 By Qing Wang | Hong Kong & Steven Zhang | Shanghai Inflation Forecasts: A Demand-Side Perspective In a recent research note, we discussed the inflation outlook for 2010 from a demand-side perspective (see China Economics: Worried About Inflation? Get Money Right First, October 19, 2009). The conclusion was that "concern about potentially high inflation in China in 2010 is unwarranted. We forecast the average CPI inflation to be about 2.5% in 2010". In particular, we argued that "predicting high inflation in 2010, based on the strong growth of monetary aggregates so far this year, could err on the side of being too simplistic and mechanical. First, the strong headline M2 growth so far this year substantially overstates the true underlying monetary expansion, as it fails to account for the change in M2 caused by the shift in asset allocation by households between cash and stocks. We estimate that the growth rate of adjusted M2 - that truly reflects the underlying economic transactions - is much lower than suggested by the high growth of headline M2. Second, generally weak export growth, which we think could be used as a proxy for output gap in China, will continue to constitute a strong headwind containing inflation pressures. These two factors combined would suggest that the 2000-01 situation - featuring relatively high money growth but relatively low inflation - would likely be repeated in 2010". Besides factors related to aggregate demand, inflation could also be caused by supply shocks. In this note, we address to what extent the CPI inflation level and profile shaped by potential supply shocks is consistent with our model-based CPI inflation forecasts from a demand-side perspective. Tracing the Impact of Supply Shocks There are typically two types of supply shocks facing the Chinese economy: one from international commodity prices and the other from domestic food prices. As a major net importer of commodities in the global economy, the rapid increase of international commodity prices tends to cause ‘imported inflation pressure': the cost pressure stemming from high international commodities prices passes through to higher prices of downstream consumer goods. In practice, the work of this transmission mechanism is reflected in the significant correlation observed between the commodity price index, PPI inflation and non-food CPI inflation. Specifically, the global R/J CRB index tends to lead domestic PPI inflation by about three months, while PPI inflation is synchronous with non-food CPI inflation. There is, however, no such close correlation between international and domestic grain prices. This reflects China's strategic policy objective of achieving grain self-sufficiency. International trade in grains - except soybean - in China is tightly controlled by the state and subject to quantity restrictions, which effectively severs the link between domestic and international prices. In fact, international grain is among a handful of merchandise items that are still subject to pervasive trade restrictions by many countries in the world. Both trade restrictions and the disconnect between domestic and international grains are the norm instead of exception in today's world. In fact, it is because of the wide difference in agricultural trade policy among member WTO countries that the Doha round multilateral trade liberalization negotiation is still in a deadlock almost seven years after its launch in 2001. The recent episode of high food price-driven CPI inflation in 2006-08 was primarily due to a sharp increase in pork prices while domestic grain prices were remarkably stable. The surge was, in turn, largely a result of an idiosyncratic domestic supply shock, namely the blue-ear disease that took place in 2006-07 and decimated the hog population. Inflation Forecasts: A Supply-Side Perspective Given the transmission mechanism from international commodity prices to domestic inflation, we can map a trajectory of future domestic CPI inflation, if forecasts of international commodity prices are available. Note that the change in crude oil prices demonstrates a close correlation with the R/J CRB index. Starting with our commodity research team's crude oil price forecast for 2010, the process involves three steps: from crude oil price to CRB index, from CRB index to domestic PPI inflation, and from PPI to non-food CPI. Specifically, we assume that the crude oil price level rises steadily from its current level over the course of 2010, reaching about US$94 per barrel by year-end such that the annual average price would be US$85 per barrel, which is the 2010 target price according to our commodity research team (see Crude Oil: Balances to Tighten Again by 2012, September 13, 2009). The year-over-year change in crude oil price will rise sharply in 1Q10 and peak at over 70% and start to decline thereafter and stabilize in the range of 20-30% in 2H10. This large swing in price change of crude oil largely reflects the low base effect. The trajectory of the forecasted change in crude oil prices will translate into the trajectory of CRB index and then to the forecasted PPI and non-food CPI inflation. Both PPI and non-food CPI inflation share a similar trajectory (with a 3-month lag to the international commodity price change): a rather sharp increase in 2Q10, peaks at mid-year, starts to decline in 1H10 and then stabilizes in 4Q10. Specifically, PPI inflation would peak at near 9%Y and average 5.2% for the year; non-food CPI inflation would peak at about 2% and average 1.1% for the year. With non-food CPI inflation likely subdued, the 2010 inflation outlook will likely again be largely shaped by changes in food prices. Unlike non-food price inflation, food price inflation will be a function of domestic factors, in our view. First, as discussed above, domestic and international markets for grains are two separate ones. Second, an abundant domestic grain supply should ensure that any potentially large volatility stemming from the international grain market would unlikely have much spillover impact on the domestic market. In particular, China expects to have another good harvest in 2009, making it the sixth consecutive year of bumper harvest. Moreover, based on a latest official survey, the inventory-to-consumption ratio stood at about 45% as of end-1Q09, more than double the 17-18% benchmark level for grain supply safety according to the United Nations Food and Agriculture Organization (FAO). Third, the current domestic grain prices are between 33% (for rice) to about 100% (for corn and wheat) higher than international levels. This is because while international grain prices declined sharply during the global economic turmoil, domestic prices were kept stable by the authorities' effort to boost famers' income. The relevant food price inflationary pressures in 2010 could stem from two specific sources: a) the government's decision to hike the minimum purchase prices of grains, which will bring about grain price increases in 2010; and b) the classical ‘hog cycle' that will likely lead to an increase in pork and other meat prices in 2010. In particular, regarding the latter, pork prices have been sliding sharply from the peak since 1Q08 and have fallen below the break-even level (i.e., 6-to-1 pork-to-grain price ratio) in June. Yet, the pork price has started to bottom out since July due to government intervention through frozen pork reserve program and some increase in production cost. According to our agricultural research team, the destocking of live hogs should extend to 4Q09 to complete the supply adjustment, which could cause substantial pork price increases (e.g., mid-teens) over the course of 2010. Taking into account these factors, we forecast food price inflation to average 7.0% in 2010, with a potential peak of 10%Y in early 3Q10. Under this forecast, food prices are envisaged to reach their previous peak level by end-1Q10 and continue to rise steadily thereafter. Combining the forecasts of non-food (two-thirds of the basket) and food (one-third of the basket) CPI inflation, we obtain the forecasts of the overall CPI inflation. Specifically, the average CPI inflation in 2010 will be about 3.0%. The inflation rate will turn positive in 4Q09 and start to rise rapidly to 1.8%Y in 1Q10, reaching 3.6%Y in 2Q10 and 3Q10 before moderating to 3.0%Y in 4Q10. The peak of the CPI inflation will likely be in July 2010, at 4.3%Y. A Robustness Test Regular readers of our reports would find that our inflation forecasts based on supply-side analysis in this report are not exactly the same as those from the model-based, demand-side analysis presented in another recent report on this subject (see again China Economics: Worried About Inflation? Get Money Right First). Readers may recall that in the earlier report, we wrote that "the average CPI inflation in 2010 will be about 2.5%. The inflation rate will turn positive in 4Q09 and start to rise rapidly to 2.4%Y in 1Q10 and 2.6%Y in 2Q10, as the lag effects of strong true M2 growth in 3Q09 and 4Q09 are only partly offset by continued weak exports. CPI inflation will likely peak in 3Q10, at about 2.8%Y, as the pick-up in export growth since 2Q10 will add to inflationary pressures despite some moderation in M2 growth." The difference in CPI forecasts between the two approaches is to be expected. We, in fact, intend to use results from the supply-side analysis to test how robust results from the model-based, demand-side analysis are to potential supply shocks. In particular, we assume that the cost pressures stemming from supply-side shocks will be able to pass through the supply chain to be reflected in the corresponding price increase of downstream products without much constraint from the demand side. To the extent that weak demand constitutes headwinds for price increases or firms choose to absorb the cost pressures through lower margins, the supply-side analysis tends to yield inflation forecasts with an upward bias, in our view. In view of the similar - albeit not the same - forecasts, we think that our model-based, demand-side analysis has passed the robustness test from the supply-side analysis. This is not entirely coincidental though. International commodity prices are not completely exogenous to China, as strong demand from China has a direct bearing on them. Policy Implications In view of this inflation outlook, we expect that the current policy stance should remain broadly unchanged towards year-end and turn neutral at the start of 2010, as the pace of new bank lending creation normalizes from about Rmb10 trillion in 2009 to Rmb7-8 trillion in 2010. Policy tightening in the form of RRR hike or renminbi appreciation is unlikely before mid-2010, in our view. If, however, excess liquidity stemming from large external balance of payment surpluses were to emerge earlier than expected, we would not rule out the possibility of the RRR hike cycle beginning as early as the start of 2Q10. Indeed, with inflation pressures likely muted, the monetary policy priority in 2010 will likely be placed on liquidity management through RRR hikes, in our view. We expect the PBoC to hike the base interest rate in early 3Q10, when CPI inflation is expected to have exceeded 3.0%Y. However, since the CPI inflation is forecast to moderate in 2H10, we expect no more than two 27bp rate hikes over 2H10, the primary purpose of which is to manage inflation expectations. In view of the current de facto peg of the renminbi against the USD, the timing of China's rate hike will also hinge on that of the US Fed, in our view. In particular, we do not expect the PBoC to hike interest rate before the US Fed. Incidentally, our US economics team expects the Fed to stay on hold until mid-2010 (see Richard Berner and David Greenlaw's US Economic and Interest Rate Forecast: Recovery Arrives - but Not a ‘V', September 8, 2009). Where We Could Be Wrong If the global economic recovery in 2010 were to be much stronger than expected, both China's export growth and the global commodity prices could surprise to the upside, likely resulting in stronger inflationary pressures and earlier policy tightening. If, however, we turn out to be wrong, it would suggest that both the global and Chinese economy would be in a much better shape than is currently envisaged under our baseline scenario. In the event of a sudden jump in international commodities prices due to financial speculation without meaningful improvement in global economic fundamentals, we do not rule out the possibility that the Chinese authorities may again resort to temporary administrative controls over upstream prices to prevent volatile financial shocks from disrupting the real economy, as was the case in 2007-08.