China’s future inflation is a present headache

Chinese inflation remains tame, but prices have been creeping up in the past few months and policymakers may not only have to step up their rhetoric but also the pace of monetary tightening to prevent Wang's fears from becoming a reality.

“I really worry that prices may rise more quickly in the future, especially for rice, meat and vegetables. After all, we can skip buying things like clothing and entertainment, but we can't skip food,” Wang said.

Inflation picked up to 1.9 percent in December, its highest in 13 months, though still low by international standards.

Some economists have dismissed the rise as a result of volatile food prices and bad weather, but these factors could profoundly affect consumer and corporate behaviour, in turn determining how fast prices may rise over the next few months.

China's central bank has been trying to fulfil its promise to manage inflation expectations this year by cracking down on speculation in the property market, curbing rampant loan growth, guiding market rates higher and lifting bank reserve requirements.

However, double-digit economic growth in the fourth quarter of 2009, accelerating consumer price rises, and surging exports all shorten the odds that the central bank will go farther and raise interest rates perhaps as early as this quarter.

“It's safe to say that this will only increase inflationary expectations, and inflationary expectations can be self-fulfilling. So there's no point for them to wait,” Qu Hongbin, chief China economist with HSBC in Hong Kong, said of the most recent batch of strong economic data.

In fact, food prices have already risen by more than five percent in the year to December and with food accounting for a third of the consumer price basket, China is particularly vulnerable to food price shocks.

In 2008, food prices spiked more than 14 percent after pig stocks were decimated by the blue-ear disease, driving overall prices 5.9 percent higher.

What should be particularly unsettling for the People's Bank of China is that its own survey results for the fourth quarter show an index of future price expectations outstripping another of future income confidence by the biggest margin in two years.

“If workers expect inflation to increase, they may argue for higher wages. If corporations see costs going up, they may want to raise prices,” said Wensheng Peng, chief China economist with Barclays Capital in Hong Kong.

“That channel is particularly important given what happened last year – expansion of bank . That in itself already generated some inflation expectations,” he said.

Falling behind?
China's growth has led the global economic recovery, so how aggressively Beijing tightens policy is crucial for international markets. Recently, investors pulled a net $348m out of China-focused equity funds, the most in over four months, fund tracker EPFR Global said in a report.

Whether China is too slow in responding to the inflation threat is hotly debated, though analysts agree that it faces an immense challenge.

After Chinese banks doled out a record 9.6trn yuan ($1,406bn) in new loans last year, they added 1.1trn yuan worth of credit just in the first two weeks of January, causing the PBOC to take punitive action against some lenders.

Furthermore, with inflation creeping up, Chinese deposit rates provide only 35 basis points worth of incentive for consumers to keep their money in the bank.

That might keep driving savers to equity and real estate markets in search of higher returns, confounding Beijing's efforts to tame asset price inflation.

Managing inflation expectations is a long established facet of modern central banking. They are a useful gauge of real borrowing costs and public understanding of monetary policy.

However, measuring where people and businesses expect prices to go is more art than science in China. It lacks a market for inflation-linked securities and has few established surveys to track consumer and views.

For now, consumer inflation is expected to be quite mild at three percent this year, a Reuters poll showed recently, well below the long-term trend of 6.4 percent.

Yu Song, a Goldman Sachs economist, expects prices to rise 3.5 percent this year – assuming the government decisively tightens policy.

He is concerned China will not adjust its exchange rate by enough to matter and exports will keep growing rapidly this year. That means the government will try to cool down domestic demand using incremental steps that may be insufficient to keep prices pressures bottled up.

“We may see inflation continuing to rise despite an apparently tightened policy stance,” Yu said in a note.

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