China’s deflation tsunami breaks

Food price inflation climbed again in China in July, surging to 6.3% y/y, from 2.9% in June. In turn, this was driven chiefly by pork – up 20.2% y/y from -6.0% – and vegetables, up 12.9% from 3.7%. If not for rising food prices, however, Chinese consumer price inflation would have fallen in July, with drops seen in services, core goods, and energy inflation, visible in our first chart below. Services inflation fell to 0.7% y/y, from1.0%, core inflation fell to 0.8%, from 1.0%, and non-food inflation as a whole slowed sharply, to 1.9%, from 2.5%, with energy CPI slowing to 27.7%, on our estimate, from 38.4%.

The surprise, relative to expectations, comes from the weakness in core inflation. The reopening of China’s economy should – in theory – have put some pressure on core, and particularly services, as consumers increased spending and enjoyed freedom. We didn’t expect it to last long, but a month’s blip is very brief. Domestic demand looks soft.

Inflation has likely now peaked. Wholesale pork prices have retreated from recent highs, and base effects will also take some of the pressure off food inflation. Core inflation is unlikely to climb much from here, particularly as the fall in PPI feeds through to core goods.

The drop in China’s PPI inflation in July was driven by a sharp fall in Mining PPI, down to 18.8% y/y from 27.3%, and raw materials PPI, which fell to 11.4%, from 15.2%. Manufactured goods inflation also slowed, to 0.9% from 2.4%, with only consumer goods inflation unchanged, at 1.7%.

Energy is clearly a big driver of the moves. By industry, coal mining inflation – which was as high as 104% y/y in October 2021 – has been steadily falling, and is now 20.7% y/y, from 31.4% in June. Petroleum and natural gas extraction PPI inflation also dropped in July, to 43.9%, from 54.4%. The production and supply of electricity, heating, and gas also saw lower inflation rates in July. These slowing upstream costs should pass into downstream inflation within the next couple of months.

Global prices for energy and industrial commodities have been falling recently, and in the case of the latter, the y/y change was negative in July. Given the lag between international prices and Chinese PPI, further declines this year – with some noise – are baked in, and we think PPI inflation will turn negative early next year.