My Blog

March 11, 2008

All the bad news and rumors of recent weeks had most analysts inching up their estimates for February CPI inflation to almost 8%.  Of course there were some who were a lot more pessimistic.  Logan Wright of Stone & McCarthy expected the number to come in at 8.5%, and MacQuarie’s Paul Cavey told me a few days ago that he believed that if the numbers were truly accurate CPI inflation would probably reach or break 9%.

As it is, the pessimists were once again the more accurate predictors.  Today’s eagerly-anticipated February CPI release by the National Bureau of Statistics had this to say:

In February, consumer price index (CPI) was up by 8.7 percent over the same month last year. Of the total, urban and rural areas rose 8.5 and 9.2 percent respectively. The price of foodstuff, non-foodstuff, consumable and services expanded 23.3, 1.6, 10.9, and 2.0 percent respectively. CPI made 2.6 percent growth over that in January of 2008.

I am not sure if I can do this, but if I read this correctly the nominal 2.6% increase month-on-month amounts to an annualized rate of 36%.  That is high.

Anyway 8.7% year on year is a pretty ugly number by itself, but of course there were a lot of special one-off factors that made things worse than they otherwise should have been.  The most important was the impact of January’s freak storms, which disrupted delivery across the south and central parts of China.  When you combine delivery constraints with the consumption binge that normally accompanies the Lunar New Year festivals in China, it isn’t surprising that CPI inflation was very high. 

How much might these special factors have affected inflation?  The hard-working staff at the National Bureau of Statistics was kind enough to tell us:

The continued increasing of CPI from this year came of the cryogenic freezing rain and snow disasters, and the Spring Festival factors. According to the preliminary estimates, Spring Festival factor affecting CPI increased 0.53 percentage points, month-on-month, while that of cryogenic freezing rain and snow disasters stood at 1.03 percentage pints, deducted these two factors, CPI in February surging by 1.0 percent approximately, month-on-month.

With a precision that would have been impressive even for the inflation counters in places like Switzerland and Sweden, the January storms and the Spring Festival are reported to have added 1.56% to February’s inflation number.  These numbers seem a tad precise for me, and I have no idea of how they were calculated, but let’s accept them as broadly accurate.  I am not smart enough to figure out how the numbers work, but my quick-and-dirty calculation suggests that without these factors, and assuming the impact was correctly measured, normalized February inflation would have still come in at 7.1%, equal to January’s already ugly number.  However you look at it the February CPI numbers were not very good.

Of course the latest CPI release still has not resolved the debate about the cause of Chinese inflation and whether or not we need to be worried.  The always-intelligent Jonathan Anderson of UBS does not seem to be overly concerned.  According to today’s Financial Times, he said that “it was crucial to acknowledge that the ‘pattern’ of inflation, which was concentrated in food, had not changed.”  The newspaper quoted him as saying “Core goods and services prices did not accelerate. Most food items did not accelerate: nearly all of the February increase came from a surge in fresh vegetable prices and a further surge in fresh meat prices.”

My friend mark Williams of Capital Economics is also less worried than I am about generalized inflation.  In a research report that came out today, he wrote:

The data on non-food inflation remain benign. Non-food prices rose by 1.6% y/y last month, little changed from the rate since fuel prices were hiked in November. Core prices, excluding energy as well as food, rose by just 1.0%, which is level with the increase in the second half of 2007.

This is strong evidence that underlying inflation is still driven by tightness in local food markets, with rising global commodity prices a lesser factor. Tighter monetary policy can clearly do little about supply side shocks. Previous rate hikes were mainly aimed at preventing real deposit rates from falling too far (which would otherwise encourage even more inflows into the overheated stock market), rather than designed to slow the economy.  (What’s more, even if hiked again shortly, rates would still be far too low relative to the growth rate of the economy to be a significant constraint on activity.) But with the stock market now cooling, there is less pressure for further rate hikes. Indeed, even if food prices drop back only slightly, headline inflation could be back below 2% by the end of the year as a result of favourable base effects.

I am not sure I agree that it is pork, and not money, in Kenneth Rogoff’s now-immortal formulation.  It is true that non-food inflation only rose to 1.6%, from 1.5% in January, but I don’t read this as benign at all.  Aside from the fact that the prices of a number of non-food components are frozen, so that their inflationary impact shows up as lower profits or tax revenues rather than CPI inflation, but the upward pressure nonetheless exists, there is a much more serious argument as to why non-food inflation is actually too high and possibly indicative of a more generalized inflationary pressure.

The way I see it, a price increase caused by a one-off supply constraint is not inflationary.  Its only effect is to cause a shift in relative prices, not average prices.  If the price of one product or group of products rises, in other words, it should cause a diversion of spending away from other goods and services, so putting downward pressure on the prices of those other goods and services.  In theory, in a perfect world, the downward pressure on other prices would net out perfectly against the rising price of the product affected by the supply constraint, and although there would be a change in relative prices there would be no inflation, which is a change in average prices

Of course we don’t live in a perfect world, and price changes would not necessarily net out.  If they did, we would need deflation of around 5-6% in the non-food component of the CPI basket to bring overall inflation back to the 3% target that had been set by the economic policy-makers in China in happier days.  By the way I base this needed-deflation calculation on January numbers – if I had used February numbers they would have been much uglier (and for the geeks out there, I acknowledge I am mixing apples and oranges because I am treating year-on-year numbers as if they were annualized monthly numbers, but this shouldn’t change the results too much, and anyway I hate false precision). 

Even in an imperfect world the impact of a 20% increase in food prices over the last year, with food comprising over 33% of the basket of goods and service consumed by the average Chinese household, should have put some serious downward price pressure on the non-food component.  It might be unreasonable to expect the 5-6% deflation in the non-food component of the CPI basket needed, but there should nonetheless have been quite a lot of downward price pressure, and it should have had at least some impact. 

Under these circumstances the fact that non-food inflation accelerated to 1.6% cannot be wholly irrelevant in deciding whether or not there is an underlying monetary cause to inflation.  I think there is, but the food-supply constraint has helped mask it by diverting increased spending towards food and away from other goods and services.  Thanks to high food prices, in other words, inflation has not yet showed up in the non-food component.  Once food prices stop rising, it will.

I think most of those on the “monetary” side of the fence agree with me that inflation is a persisting problem caused by excess money creation and is unlikely to go away soon.  The majority, who still seem to be what I call “real economy” types, disagree.  We all agree however (I think) that whether or not the cause of inflation is monetary or a temporary food-supply shock, for the average Chinese household these nominal price increases are real and are starting to hurt.  At some point, if they have not already done so, they are likely to cause upward wage pressure and may even cause an acceleration of planned spending on consumer goods, either of which would cause inflationary pressures to spread away from food.

None of the debates have yet been resolved.  We probably need to wait at least until March CPI inflation comes out, some time in early mid-April, and perhaps not even that will be enough.  The way I see it, if March inflation is above 6%, the inflation rate for the first quarter will be higher than January inflation and so we would have reason to believe that inflation is continuing to accelerate.  I am assuming of course that the reversal of those factors which unfairly drove up inflation in February should “unfairly” drive inflation down in March.  That is why the “danger” level should be much lower than the January or February CPI inflation numbers.  We can only wait and see what happens.

On another topic, a related debate that has attracted a lot of interest is whether or not food inflation is, in an admittedly clumsy way, helping policy-makers achieve one of their very important goals, that of income redistribution from the relative rich cities to the very poor rural areas.  The argument is that China needs a more equitable income distribution, and high food prices are one way to divert income from the cities to the farms. 

Not everyone agrees that this is happening.  Some of my Chinese friends tell me that there are several constraints on the ability of farmers to benefit fully from the price increases (price controls and rapacious government-related middle-men are among the reasons often cited).  They are also suffering from consumer inflation as well as the high cost of inputs.  According to the CPI release by the National Bureau of Statistics, rural inflation was worse than urban inflation – 9.2% versus 8.5%. 

An interesting piece by Xinhua today explains why this may cause problems in redistributing wealth:

For Chen Baoquan, the recent price rise in agricultural products, although welcome, did not make him any happier as production and living costs were also up.  The 46-year-old farmer once thought, by taking advantage of rising crops prices, he could earn extra money to improve his family's living standard.

…His dream, however, did not come true as the surging prices of agricultural production materials and the high overall price level erased the gains from crops sales.  Chen…said the 500 kilogram of wheat produced by one mu (0.067 hectares) of land, on average, could be sold for 800 yuan (112 US dollars) as the current market price was 1.6 yuan per kg.

After deducting the production materials costs, including those for fertilizer and irrigation, the gross earnings, including labor, were only 500 yuan, he said.  “This (earnings) is almost flat from a couple of years ago. Though the wheat price rises by 0.2 yuan per kilogram, our production costs also surge.”  He cited a 50-kg bag of compound fertilizer as an example. It had jumped to 200 yuan from 130 yuan a year ago.

The prices that started to rise since the beginning of last year had greatly eroded the purchasing power of hundreds of millions of low-income farmers like Chen.  “My family earns 5,000 yuan per year by growing crops. That could meet our living costs a year ago, but now that can no longer make ends meet,” he said.

The point is that not only have input costs risen, sometimes faster than the price of food, but as the farmers are increasingly integrated into the market economy they become increasingly affected by rising market prices.  Chen Xiwen, director of the office of the central leading group on rural work, is quoted in the article as explaining why:  “People often see the benefits brought to farmers by the surging prices of agricultural products, but that is only one side of the coin,” director Chen said. “Increasingly, more farmers are no longer self-sufficient. They also buy many consumer products, including food, at the markets

It is interesting that this article was published.  Of course it contains the obligatory recital of how successful the government has been in alleviating the problems (the article concludes with: “All the pledges have helped to allay farmer Chen's concerns of higher inflation.  “They have demonstrated the government's determination to rein in inflation,” he said.  “I believe the government can finally manage to ease inflation after taking timely and effective measures.”), but it nonetheless paints a pretty depressing picture of the plight of the farmers.

Comments (18) for "Why low non-food inflation d...

Great post Mike -- thanks. I have combed through the CPI line items one by one and I am left with a feeling that more subjectivity than usual may have gone into these inflation numbers. There is widespread anecdotal evidence of white goods price hikes, reflecting pass thru of steel cost hikes more than monetary or snowstorms per se, I should think. But the household consumer durables inflation figures were about flat over January, and just 100.8 from last year. Also, the vast majority of the specific provincial averages reported inflation levels below the 8.7% putative national average. Some provinces are not reported monthly PY=100, so I am not sure about this; but some of the snowstorm affected ones are, and they didn't show up above the average. Very strange I think. By DHR - 3/10/2008 10:50 PM

On prices: -If we assume that all pork disappeared tomorrow, then prices of other foodstuffs would RISE. -If we assume that pork remains the same tomorrow, but for marginal elasticity reasons, just a small increase in demand raises prices by 50%, then prices of other foodstuffs would FALL. Clearly, the second alternative applies to China. The mirror image of the exhaustion of consumers purchasing power, would then of course be increasing profits among pork-producers. This is probably the case, but this income is not channeled into food-stuff purchases, but obviously into other markets. Thus I agree with Mr Pettis, other prices would have fallen as a result of increasing pork (etc.) prices, had monetary conditions been neutral. Now, pork (etc.) turned out to be the bottle-neck which absorbed the monetary pressure. A similar pattern has been evident in the west, where oil has been the absorbant of easy money, due to its low price elasticity (short-term). By Stefan, Tallinn - 3/10/2008 11:31 PM

Tallinn, It is a basic Econ 201 question. Pork price spike is caused by a supply shock. The result is price goes up and quantity goes down. For other food stuff, they are substitutes of pork. When there is an increase in the pork price, other food stuff prices and quantities should also go up. By fatbrick - 3/11/2008 5:11 AM

Michael, It looks like US Fed is hell-bent on giving the "credit addicts" the very same drug (i.e. $200bn loan/credit today) that did them in so that they wouldn't go in withdrawal. Any comments on its ripple effect to FX and inflation situation relative to China's financial market? By zh - 3/11/2008 5:29 AM

Today Fed's move is pretty brilliant. It effectively lends out government credit to bad debt papers to stop chain crash in short term. It should have little impact on FX or inflation IMO. It might even have some positive effect on FX in short term, since now Fed rate cut expectation is lower. Fed is actually betting that underlying economy is better than market belief or the fundemantal improves faster than the policy losing impacts. By fatbrick - 3/11/2008 6:42 AM

fatbrick If pork would have had a substitute, then a 50% increase in its price would not have been possible. Rather, pork is for China what oil is for the west. Price elasticity is low, substitues are few, and it quickly starts to drain purchasing power from consumers, when it rises - as a consequece of accomodative monetary policies. Therefore, the absense of price-falls of other products, indicate that easy money has caused the pork (and oil) chock. By Stefan, Tallinn - 3/11/2008 7:05 AM

To be frank, I am not sure what it does and to what in the short term in the US. From what I see there are, in fact, plenty of cash lying around. Investors (institutional investors) are simply hoarding cash. If the consecutive interest rate cuts did not work, I am skeptical what an additiona $200bn would do. One thing is almost certain, little will be downstreamed into the capital market. CMBS, RMBS, Consumer Loan, Equipment, Transportation, Manufacturing... not a single market looks promising and show downward momentum, I wonder where the additional $ will go... except looking East (Near and Far East)... By zh - 3/11/2008 7:10 AM

If I may extend on oil China and the US (and to a smaller extent Japan) compete for the world's oil. Through future markets they can guarantee themselves supply. China and Japan have massive dollar assets to buy oil. Only China's currency reserve yields an interest income close to 2 mln/bbl per day or something like half of China's oil imports. But however massive these currency reserves are, the Bernanke printing press is even more powerful, and will always out-compete any (USD) currency reserve. The Arabs may print oil future contracts for decades, and the US will print treasuries in return for these. For this reason it will be difficult for China to get enough oil for its growth, going forward. Someone else must consume less, but the Europeans have already reached a super-effective consumption through high taxes, so it is the US and the Chinese consumer who will strive for the same oil. Since the oil exporters do not buy consumer goods for the money they make, there is only litte spill-over into consumer prices coming from the competition for oil. Treasuries are printed in return for oil futures contracts. True, today the American oil-consumer is somewhat squeezed, but theoretically the US could do as China, subsidise oil, with some additional treasuries printed. And simplified, the more oil China tries to buy, the quicker the US will have to dilute the value of the greenback and the treasuries. By Stefan, Tallinn - 3/11/2008 7:32 AM

Tallion, Easy money goes to pork? Do you really know anything about the production-consumption structure in pork industry in China? Food sector as a whole accounts for a bigger share of people's buying power. It is other consumption sectors have been negatively affected. There are plenty of evidence of price-falls, such as cloth, automobile, computer, cell phone...... and you could count stocks and houses in too. By fatbrick - 3/11/2008 8:48 AM

A masterful exposition. I spend a lot of time reading research reports and talking to economists, and although I don't fully agree with all your points, I have to say this is the best thing I have ever read on Chinese inflation. Thanks, and keep it up. By PP - 3/11/2008 4:17 PM

Fatbrick Why do you count falling real estate and stock prices as evidence of deflation without counting formerly rising prices as evidence of inflation. Since prices of both stiocks and real estate shot up in 2007, are you saying that China had a serious problem with monetary-based inflation in 2007, and now thanks to tightening it has disappeared? By TR - 3/11/2008 4:30 PM

Thanks Dan. Measuring inflation is always a problem in such a rapidly-changing society, but I agree there has been a lot of anecdotal evidence suggesting that CPI is not fully capturing price changes. I keep hearing that provincial producers are sneaking in price changes without reporting them. I don’t know for sure, but I would be surprised if that wasn’t happening, at least to some extent It would be very hard to argue that in China (or anywhere else for that matter), rules and regulations are followed very strictly when there is a strong incentive and little cost to disobey. By the way thanks to the 20% price increases for food in the last year I really don’t think it is fair to keep the food component of the CPI basket steady at 33% of the basket. According to the press a lot of Chinese households are complaining that they are spending more on food now than they were in the recent past. If it were adjusted CPI would end up 0.5-1.0% higher, I estimate. Stefan, the oil analogy is, I think, a good one. Inflationary pressures can be absorbed when the cost of any particular product rises very quickly for whatever reason and that product is an important and inelastic part of the consumption basket. As long as the product rises in price, it will absorb the underlying inflationary pressure, but once it stops it will no longer act as an inflation absorber. ZH, I too am worried by the “cash lying around”, not just in China but in the whole world. It has to go somewhere. My guess is that once the crisis is perceived as having turned a corner we will see asset prices and credit spreads snap back. Fatbrick, there are certainly many goods and services in China whose prices have fallen, but in every economy at every time (except during hyperinflation) there are many goods and services whose prices rise and others whose prices decline. The point is what is happening on average to the value of money, not whether or not there is a shift in relative pricing among goods and services. The former is about inflation, the latter about changes in consumer behavior and in relative costs. Actually the fact that prices of so many things in China have fallen in the past few years strengthens, I think, my case. One argument against my model is that prices are so sticky downward in China that it is impossible for counterbalancing adjustments to take place even in a non-inflationary environment, but in China that does not seem to be the case. PP, thanks. By Michael Pettis - 3/11/2008 4:46 PM

fatbrick The Chinese export industry supplies the whole outside world with REAL goods. But it only supplies China with RMB-notes. This is the easy money I talk about. The larger the export sector, and the higher the wages, the more extreme this situation is. That's why you see pork prices soaring, I think. By Stefan, Tallinn - 3/11/2008 4:53 PM

Tallinn, I cannot see your logic here. Every business in every country supplies real good and real service for a piece of paper. Do you imply they are all easy money? TR, What I suggest is that consumption-savings ratio. Since necessity goods prices become higher, people might adjust their consumption-savings ratio. For individual investors, they invest their savings in stock markets. Thus, if they took some savings to consume, there would be some downside impact on stock market and real estate market. Of course there are many other factors behind asset markets. By fatbrick - 3/11/2008 9:04 PM

fatbrick Ok, I am referring to what is happening on the margin, i.e when imports are already paid for. The Chinese PEOPLE have seen the value of their bank savings eroded by inflation. The Chinese STATE has seen the value of their treasuries-savings eroded by inflation on all meaningful import goods needed. What is the value for China of making another 1 BUSD to put on top of the others some 1 600 BUSD already made? - Very low. What is the value for China of producing goods worth 1 BUSD for the local market? - Very high. By Stefan, Tallinn - 3/12/2008 12:28 AM

I am still not following you. Are you talking about marginal utility? There has been export declining and demostic retail sales increasing. This is affected by both weaker demand in oversee markets and stronger RMB. I am not sure it has anything to do with utility. If you are talking about marginal revenue, there is little difference between export and demostic markets because of the law of one price. By fatbrick - 3/12/2008 1:21 AM

fatbrick yes, we may say that the marginal utility of increasing exports is low for China. =The marginal utility of an increasing currency reserve is low. By stefan - 3/12/2008 5:56 PM

one things is clear, the 1.6% non-food prices rise is also decade record even when key non-food prices such as gasoline, power are frozen. By isaac - 3/13/2008 5:50 PM