Benign Inflation Presents No Constraint For PBOC’s Easing

Headline CPI in China moderated to +2.3% y/y in June from +2.5% a month ago. This was compared with market expectations of a milder ease to +2.4%. The disappointment was mainly driven by food price inflation which decelerated to +3.7% y/y in June from +4.1% in May. Non-food inflation stayed flat at +1.7% y/y. Underlying inflation pressure in China should remain benign and is overall CPI inflation is expected to stay well-below the +3.5% target set by the government. Meanwhile, soft inflation pressure should not constrain PBOC’s monetary easing and policymaker should implement stimulus in the form of rate cut or RRR cut to lower the funding cost and bolster growth

The decline in food inflation, the key cause of the decline of headline CPI (year-over-year) in June, was resulted from the stabilization in pork prices. Yet, pork prices gained on month-over-month basis for 2 consecutive months in May and June. PPI deflation eased to -1.1% y/y in June from -1.4% y/y in May. PPI deflation moderated to the slowest since April 2012 was indeed partly helped by a low base last year. Looking into the details, PPI for steel and coal continued to stay soft, indicating overcapacity in some industries persisted.

Soaring oil prices in mid-June due to tensions in Iraq and Libya raised concerns over the impact on China’s CPI. The reading suggested that the impact has been small. Indeed, energy price directly makes up about 6.5% (of which fuel takes up around 2%) of China’s CPI basket. However, the impact in the medium to the long term may be higher as oil and fuel are intermediate inputs for various products and services.

Inflation pressure in China is expected to remain soft in coming month. Together with persistent PPI deflation, policymakers should feel comfortable in adopting easing policies which are needed to boost growth in 2H14. On the fiscal front, the government would likely increase spending. More infrastructural projects should be opened for investments by private sectors. On the monetary front, both rate cut and RRR cut should be considered. Interest rate reduction of -25 bps in each of 3Q and 4Q is plausible. The PBOC has also been working on a new monetary policy tool called Pledged Supplementary (PSL) to lower funding costs for some government sponsored borrowers and to lower lending rate in the medium term. Awaiting more details of the PSL, we remain skeptical over execution of the facility as lending rates of PSL could be below market rates with similar loans. The lack of transparency of the facility would also allow the central bank excessive power in funding allocation.

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