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Food and meat prices are likely to rise further in the coming months. Food and poultry prices have been rising at annual rates of 18 per cent and 40 per cent respectively recently, and these price pressures may push up the headline inflation rate to over 8 per cent in the next couple of months. Inflation expectations are also rising: A recent Chinese central bank survey shows that 65 per cent of respondents expect prices to rise, compared to only 50 per cent a few months ago. Such rising expectations could create a self-perpetuating process. International Monetary Fund research shows that inflation expectations explain 60 per cent of future inflation in some developing countries. Meanwhile, prices of Chinese corporate goods have been rising, suggesting that some of the rising costs are being passed on to consumers. Chinese corporate prices for consumer and agricultural goods have been rising at an average annual rate of more than 9 per cent since the middle of last year. Because the pricing power of businesses outside the food and energy sectors remains constrained, the core inflation rate has remained subdued. But rising inflation expectations is creeping into the core rate too, which rose from about 0.5 per cent last year to 1.5 per cent this January. The Chinese authorities face a challenge preventing inflation from spreading further. Indeed, China's central bank stressed in its recent policy statement that it would keep its tight policy bias for the rest of the year. It also indicated that it would allow more yuan flexibility to help curb inflation. This implies the central bank would tolerate an appreciation of the currency. But, confusingly, the damage to agriculture and infrastructure (including power facilities and communication links) that the recent winter storms inflicted argue for a policy relaxation. Powerful political interests are already urging the government to ease credit policy and investment approval procedures and increase budgetary spending for reconstruction. These demands will clash with the need to curb inflation expectations and may create highly uncertain policy milieu. If the authorities see a significantly higher inflation rate, together with strong money and credit growth, in the next couple of months, they may tighten policy further, risking overkill in the near term. However, if political considerations prompt them towards a substantial policy easing, a quick reversal would be likely, given the temporary nature of the winter storm damages and rising inflation expectations. Such reversals will aggravate policy volatility and hurt Beijing's economic management credibility. With the Chinese central bank's higher tolerance for yuan appreciation, we may see the currency rise by an annualised rate of 8 to 10 per cent in the short term. But the pace of the yuan's appreciation will likely ease in the second half of this year when the drag from slowing global demand might prompt a policy shift by the central bank. Under these circumstances, investment strategy should focus on overweighing sectors that are least vulnerable to the risks of worsening inflation and policy interventions, and a sharp US slowdown. These sectors may include gold, telecoms and selected oil and energy stocks. Banks, property and commodities are more geared towards macro conditions and would thus have an unfavourable outlook in the short term. The writer is the director of investment research at Ping An of China Asset Management (Hong Kong).
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