China's CPI fall confirms its inflation is driven by international commodity prices and China has room for stimulus

The present author has consistently pointed out that China’s consumer price inflation (CPI) is primarily driven by international commodity prices and not, as some have argued, by monetary conditions in China – for a more extended recent analysis see ‘Key Trends in China’s Inflation’ which appeared in China Daily. This fact is strongly confirmed by China’s new CPI data, showing a fall to 4.2% from October’s 5,5% and a peak of 6.5% in July. To illustrate this Figure 1 shows both international commodity prices and China’s CPI. The tight correlation of the two is evident.

Figure 1

 

To deal with the argument that correlation is not necessarily causation, the direction of causation between international commodity price indexes and China’s CPI inflation is clear. China’s CPI is simply not a sufficiently large factor in the world economy to determine world commodity prices. In terms of causality, therefore, either world commodity prices cause the changes in China’s CPI or a third factor, for example international supply and demand, causes parallel changes in both. In either case examining international commodity prices allows trends in China’s CPI to be predicted.

This close correlation gives good news for future trends in China’s CPI and therefore for the ability of its government to stimulate the economy. Year on year changes in international commodity prices are currently falling rapidly. The year on year change in the daily Dow Jones-UBS international commodity index has dropped from a maximum of plus 52.8 per cent in March to minus 0.5 per cent on 7th December. Given the close correlation between China’s CPI and international commodity prices these sharp falls in commodity prices create good conditions for China’s fight with inflation.. This in turn increases the room for the government to stimulate the economy.

At present the international economy as a whole faces overall stagnation in the developed economies rather than a large 2008 style downturn - despite the recession in Europe. China does not require a full scale 2008 type stimulus package, but loosening of economic policy is clearly increasingly possible. This will ensure there is no large fall in China's GDP growth.

China's latest CPI data are therefore important in confirming:

• The real causes and therefore dynamic of China's inflation.
• The slowdown in inflation gives China the economic room for manoeuvre to loosen economic policy and ensure a 'soft' and not a 'hard' landing.