China’s headline CPI for February came in at only 0.8% YoY, much lower than market expectation of 1.7%, and in stark contrast to the 7.8% reading on PPI inflation. More interestingly, such a weak headline CPI reading was entirely driven by a 4.3% decline in food prices, while non-food price inflation was a positive 2.2%. What were the factors behind the weak food price inflation? How long will the trend likely continue?

In this report, we analyze how supply side reform in the agriculture sector, particularly in corn supply, may affect headline CPI inflation over 2017~18. Our main findings are quite interesting:

1. Since China’s grain prices have been significantly higher than international prices, supply side reforms that allow the market to play a bigger role in price discovery will likely result in a decline in food prices, and thus CPI. In contrast, supply-side reforms in the industrial sector, which reduce government support for inefficient producers, tend to lift China’s PPI, and thus global manufacturing prices.

2. China abolished its corn price support policy in March 2016, and domestic corn prices have fallen by 20.6% since then, and reported a 21.3% YoY decline in January~February this year. Given 70% of the corn is used as feed stock, we believe such a substantial decline in corn prices has also contributed to the weak pork and other meat prices.

3. At present, China’s domestic corn prices are close to international prices after shipping expenses etc. are taken into account. However, the government still holds a large inventory of corn, which we expect to be gradually released to the market to make up for a small projected deficit in supply-demand balance this year. As a result, we believe food price inflation – and therefore headline CPI inflation – is likely to remain muted for most of this year.

4. However, non-food CPI has been running at >2% YoY since December 2016, and will likely be pressed higher given the strength in domestic demand. Moreover, the favorable base effect from the decline in corn prices will likely dissipate after 3Q this year.

5. If oil prices stay within the US$50~$60/bbl price range, and most commodities’ prices remain range bound, we expect China’s food price inflation to turn positive around 1Q18, leading to a rise in headline CPI inflation towards 3% or higher in 2H18.

Looking forwards, both agricultural and manufacturing supply side reforms will likely continue, leading to a muted CPI inflation reading, an elevated PPI number, and a wider PPI-CPI gap for the next 2~3 quarters. How will monetary policy respond to this? Our view is that the central bank’s next policy moves will likely be further withdrawing stimulus, not easing, but their tapering will likely be very careful and moderate in 2017, given their concerns over the sustainability of the economic recovery and risks in the financial sector. We expect the PBoC to raise the policy reverse repo rates by another 20bps this year, and use window guidance to rein in robust credit demand, but not to raise the policy benchmark deposit or lending rates. However, when the favorable base effect from food price decline disappears next year, the PBoC may need to shift to a more aggressive tightening stance to keep CPI inflation <3%.