Inflation edged up to 6.5 percent in July, with food items accounting for more than two-thirds of the rise. In particular, pork prices remained elevated. The good news is that for non-food items, price increases moderated this month. Moreover,  the momentum of inflation appears to be waning, with the month-on-month increase in prices falling to about half the rate observed in June. At the same time, imported inflation may also decline in light of the recent sharp falls in international commodity prices.

What does all of this mean? Like many others, the IMF had expected inflation to remain relatively elevated this month. With the effects of last year’s bad weather-induced food supply shocks easing and the People’s Bank of China’s tighter monetary policy, inflation should peak in the coming months before falling back to the government’s target of 4 percent by the end of the year. As shown by the recent pork price episode, however, the main risk is from unexpected weather or disease-related food shocks that could elevate and prolong the inflation cycle.  

The government has the right measures in place. In particular, it is essential that people’s inflation expectations remain under control in the coming months. Implementing the tighter monetary policy planned for this year will be key. This is currently being achieved predominantly through slower credit supply. More emphasis on increasing interest rates would also contain the demand for credit by borrowers. Meanwhile, to ease the burden on the most vulnerable groups such as the urban poor and rural households not engaged in farming, targeted food subsidies could be considered, while reducing reliance on administrative measures. Such measures dampen prices in the short run but also suppress incentives for increased supply over the medium-term. This could be particularly damaging in the case of agricultural products, for which demand will continue to rise as China urbanizes and becomes richer.

[Also see http://epaper.21cbh.com/html/2011-07/18/content_3074.htm?div=-1 and http://www.chinadaily.com.cn/usa/2011-07/28/content_13001291.htm]