China’s Consumer Price Index (CPI) jumped 3% year-over-year in September, the highest reading in six years, and importantly, it breached the People’s Bank of China’s (PBOC) annual target of 3%.
What caused the sharp rise in CPI, and what are the implications for China’s monetary policy and bond market?
After examining what’s driving the rise, we are not overly concerned for a few reasons.
- September CPI does not reflect broad inflation pressure in the economy but rather a negative supply shock: African swine flu is spreading throughout the country, causing a 30% loss in pork supply (15 million−16 million tons out of annual demand of 55 million tons). As a result, the price of pork jumped 69.3% year-over-year in September and 19.7% from the previous month. Given a 2.4% weighting in the CPI basket, the price of pork contributed 165 basis points (bps) to the 3% rise in headline CPI.
- Core CPI excluding food and energy actually dropped to a three-year low of 1.5% year-over-year, and at the same time, Producer Price Index (PPI) industrial deflation has deepened to −1.2%. Clearly, there is no demand overheating, which is typically associated with broad-based inflation or stagflation. In fact, domestic demand is weakening, while employment, consumption, and corporate capital expenditure are all slipping.
- The negative pork price shock is unlikely to ease anytime soon, and we think meat prices will be the main factor driving headline CPI over the next six to 12 months. However, we expect headline CPI to peak around the Chinese New Year in late January before stabilizing.
Impact on monetary policy
Theoretically, PBOC monetary policy should look through the pork-price shock. Weak growth and the fall in broader inflation gauges, such as core CPI, PPI, and the GDP deflator, suggest that further easing is warranted, and so far, the bond market’s reaction to the September CPI jump has been quite muted.
However, headline inflation resulting from a food price shock can never be ignored fully: Food makes up 30% of the consumer basket and an even higher level in rural and low-income households. The potential effect on inflation expectations therefore warrants some caution and creates a temporary constraint for PBOC easing.
Our baseline is that the PBOC will maintain a patient, reactive easing stance. While we expect the central bank to cut interest rates by 50 bps by the end of 2020, we think it will most likely keep rates on hold into year-end and until headline CPI has peaked, likely in the first quarter next year.
For more on China, see our global cyclical outlook, “Window of Weakness.”
Isaac Meng is an emerging Asia portfolio manager with a focus on macroeconomic and financial analysis of China. He is a regular contributor to the PIMCO Blog.