China: Drop in inflation boost to growth

In China consumer price inflation again decreased sharply to 1.6% y/y in September (consensus: 1.7% y/y, DBM: 1.8% y/y) from 2.0% y/y in August. This is the lowest level in China since January 2010. The decline in inflation was primarily driven by lower food and energy prices. According to our estimate, lower energy and food prices in September subtracted 0.1pp and 0.2pp respectively from the year-on-year increase in consumer prices. Core inflation excluding food and energy eased slightly to 1.5% y/y from 1.6% y/y in August and core inflation has so far only eased marginally since the start of 2014.

Looking ahead there should continue to be substantial downward pressure on inflation from lower energy and food prices in October. At the moment our estimate indicates that CPI inflation is poised to drop to at least 1.3% y/y in October, although it obviously will depend on the development in crude oil prices and when retail gasoline prices are cut. If crude oil prices stay at current levels, CPI inflation will remain markedly below 2% y/y for the rest of the year and a print below 1% y/y in the coming months can no longer be ruled out.

It should be underscored that the current sharp decline in inflation is not of the ‘destructive’ kind in the sense that it will probably boost domestic demand. The recent sharp decline in inflation in China has mainly been driven by external factors and only to a lesser extent by slower growth domestically. China is one of the countries benefiting most from the global decline in energy and commodity prices. The decline in inflation will boost consumers’ purchasing power and corporate margins will improve. Hence, the decline in inflation will boost domestic demand in China. The substantial terms of trade gain for China has also been evident in China’s trade balance surplus that has surged in recent months.

Will the substantial decline in inflation force the People’s Bank of China (PBoC) into a more substantial monetary easing, for example an official interest rate cut or a cut in the reserve requirement? Probably not although there is now certainly room to cut interest rates if needed. China’s monetary policy at the moment has a relatively weak link to inflation. The official 3.5% target for inflation should mainly be regarded as an upper limit for inflation and PBoC has never communicated a lower bound for acceptable inflation. This is a bit dangerous, but it gives PBoC more leeway to focus on other goals in its monetary policy particularly containing credit growth. Hence, we expect PBoC to continue to ease monetary policy only cautiously by minor targeted easing measures. However, should the property market fail to stabilise in the coming months, it would in our view make a lot of sense to cut interest rates.