Strong Chinese Consumer Price Index (CPI) data for February suggest the world’s second-biggest economy will no longer be a source of global disinflation.
China’s CPI rebounded by 2.9% year-over-year (YoY) in February, the strongest rise since 2013. Although the Chinese New Year holiday boosted food prices in February, the less volatile core CPI, which excludes food and energy, accelerated 2.5% YoY (versus an average 2.2% over the past three months) ‒ the fastest pace since the fourth quarter of 2011. And services prices rose more than 3% YoY ‒ the fastest pace in six years.
We expect China’s CPI to maintain this momentum and average 2.7% in 2018, a marked change from 1.6% in 2017. Although still below the target of 3% set by the People’s Bank of China (PBOC), we expect the central bank to continue normalizing monetary policy this year.
Inflation momentum in China
In addition to China’s latest CPI, other signs point to sustained inflation in the country over the next year.
A tight labor market and above-potential growth: Most academic studies suggest China’s output potential is gradually slipping due to its aging population, and the 6.9% GDP growth rate of 2017 was above potential. The signs are clear in the labor market, where more reliable survey-based data show the urban unemployment rate has dropped to an all-time low of 4.98%. With the labor force peaking, high-single-digit wage growth should support core CPI and prices for labor-intensive services.
Industrial overcapacity falling due to supply-side structural reform: Since 2016, China’s policymakers have aggressively enforced cuts in heavy industrial capacity. By our estimates, 120 million tons of steel capacity (15% of the total capacity) and 400 million tons of coal capacity (10%) have been permanently shut down in the past two years. As a result, industrial capacity utilization in the fourth quarter of last year rebounded to 78% from its 73% trough in the first quarter of 2016, while China’s Producer Price Index (PPI) gained nearly 11%. Despite tightening monetary policy, this much-improved balance of industrial supply and demand should support upstream prices.
A stable currency: The Chinese yuan is generally stable or strengthening rather than facing persistent devaluation pressure as in 2015–16. In addition to falling commodity prices, the sharp devaluation of the yuan two years ago was a major transmission channel of Chinese domestic disinflation pressure to the global economy. Since 2017, however, the PBOC has successfully balanced currency outflows and reversed devaluation pressure through a combination of macroprudential control, liquidity tightening and intervention.
Stability in 2018
We expect these conditions to continue through 2018. Chinese reflation is likely to be sustained by the tight labor market and rising core consumer prices, while supply discipline and a stable currency should mitigate disinflationary effects from China on commodity prices and exchange rates. Although CPI will probably remain below the target of 3%, we expect the PBOC (under new governor Yi Gang) will continue to focus on its goals of “normalization of rates and financial risk control,” and continue raising interest rates gradually.
Isaac Meng is an emerging markets portfolio manager with a focus on macroeconomic and financial analysis of China. He is a regular contributor to the PIMCO Blog.