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The People's Bank of China should have room to tolerate a gradual rise in consumer inflation expected to result from a sustained rise in factory-gate prices, policy advisors told MNI, though they disagreed over whether the PBOC would be able to loosen policy in the second half of the year in order to revive weak domestic demand.

Local commodity sourcing capacity has been constrained after years of supply-side reform, and producers may be reluctant to increase output at a time when they are benefitting from soaring prices, so high prices could last longer than expected, said Chen Daofu, vice-director at the Financial Research Institute at the State Council's Development Research Centre. This would in turn drive consumer inflation higher, he said, speaking after China acted last week to boost supplies of copper, aluminium and zinc by releasing some stockpiles.

While advisors said producer price inflation is reaching its peak after May's 13-year-high 9%, they called for further measures to increase supply, with some saying the PBOC should also ease policy to support demand.

SQUEEZE

Higher input costs are squeezing margins for downstream manufacturers, some of which are now barely making a profit due to the squeeze on their margins from higher input prices, according to Chen.

Core CPI, excluding volatile food and energy prices, could approach its historical average of 1.5% this year, from its current 0.9%, Chen said, though he noted that headline inflation was unlikely to rise much over 2% due to a fall in pork prices which could continue for two or three quarters. Wen Bin, chief researcher at China Minsheng Bank, said that inflation could come in at 2.5% this year while PPI would average around 6%.

Weak demand and relatively tight credit conditions have curbed the feed-through from producer into consumer prices, said Li Gang, senior fellow at the National Institution for Finance and Development, one of those who thought that the PBOC could ease credit conditions in the second half of the year as the economy slows down despite rising inflation.

Total social finance, a broad measure of lending, fell to CNY31.5 trillion at the end of May from a peak of CNY35.3 trillion last November.

DIFFICULT BALANCE

Echoing comments by Yu Yongding, a former member of the PBOC's monetary policy committee, who told MNI earlier in June that authorities should allow slightly higher inflation in order to push growth closer to potential, Chen Fengying, former director of the World Economy Institute at the China institute of Contemporary International Relations, said China's supply and demand would be better balanced with headline annual CPI growth at about 2.5%. This would be much closer to its 3% target and compare to 1.3% in May, she said.

But a policy advisor who asked to remain anonymous said the PBOC might face a difficult balancing act and could be forced to tighten policy if prices rise too fast, as well as potentially coming under pressure to loosen to support the economy. For the moment, with CPI still below the 3% target, the central bank does not feel compulsion to act, the advisor said. Nonetheless, CPI is beginning to edge up as a result of producer price increases, after excluding pork prices, he said.

Chinese authorities, having learnt the lessons of their 2008 and 2009 policy easing, will not allow inflation to rise too high, said Chen Fengying, adding that even if the PBOC cuts policy rates it will do so cautiously, given the priority placed on reducing economic leverage and given the large share of national wealth now made up by property.

Future drivers of inflation may come from pork prices, which may have hit bottom, and the campaign to limit China's carbon emissions, which will require huge investment and innovation, Chen Fengying said. With the Federal Reserve becoming more hawkish, a weaker yuan, as low as 6.8 to the dollar, would be welcome to the PBOC, delivering a boost to exporters, she added.