Jun 04, 2021 Macro

Inflation made in China

China's producer price inflation could soon reach a new peak. This is not, however, a harbinger of consumer prices spiraling upward too, nor for new monetary tightening.

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Inflation is rising across the globe. Causes, implications and outlook, however, vary. In China, the steep rise in producer prices (PPI) is making headlines. Their year-on-year increase of 6.8% already reported for the month of April, compares to -3% a year ago. Leading indicators such as the price components of the latest Purchasing Managers' Indices (PMIs) suggest that the peak is yet to come. In this context, producer prices for the month, due on June 9, could well exceed the 8% mark.

The correlation between PPI and CPI has been declining for years and is currently only 0.3 (compared with 0.7 just five years ago).

The main drivers of producer prices are raw materials and input prices, which in part reflect strong global demand and inventory restocking due to the economic recovery in the United States and other countries. Supply-side bottlenecks are also driving the PPI up, such as copper. The base metal is mainly produced in South America and Africa, where the Covid pandemic is still acute and vaccination is not yet well advanced. In addition, there are some China-specific reasons: For example, authorities restricted capacity and production of some intermediate products to reduce domestic air polluting emissions. Rising steel exports, in turn, led to further price increases in the domestic market, as did speculation-driven activities in the coal market.

Consumer prices captured in the consumer price index (CPI), on the other hand, are strongly driven by food prices, which have quite different seasonal patterns and base effects. It should therefore come as no surprise that PPI and CPI do not move in sync, and that the PPI also hardly has a leading function for the CPI, as can be seen from our Chart of the Week: the correlation between PPI and CPI has been declining for years and is currently only 0.3 (compared with 0.7 just five years ago).

20210604_CotW_China Inflation_CHART_EN_72DPI.png

Sources: Haver Analytics and DWS Investment GmbH as of April 2021

Consumer prices have also seen an increase recently:

from negative levels in the first quarter to most recently 0.9% year-on-year in April. Economists expect an increase to 1.6% in May. However, there is still a long way to go before the central bank's target of 3% is reached. Dr. Elke Speidel-Walz, Chief Economist Emerging Markets at DWS, expects consumer price growth to be around 2% in the third quarter and then to accelerate above 3% in the final quarter of the year. That would lead to an average of 1.7% in 2021. Nevertheless, she does not see strong general price pressures in China. Unlike in many developed countries, China has had neither a strongly expansionary monetary policy nor consumption-oriented large fiscal programs. Inflation excluding food prices is running at moderate levels.

Will the People's Bank of China (PBoC) respond to rising producer prices by tightening? Elke Speidel-Walz does not expect it to, as long as the rise in producer prices is seen as a temporary phenomenon especially if commodity prices do not continue to increase sharply. In such an environment, it seems unlikely that the rise in the PPI will spill over into consumer prices, thus prompting the central bank to act.

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