China's January CPI inflation figures came in at a lower-than-expected 4.9 percent year-on-year (YoY), while the PPI (producer price index) inflation surged to 6.6 percent.

A detailed look at the CPI data released Tuesday suggests that the downside surprise in the January CPI inflation was mainly attributable to below-consensus food price inflation rather than the changes in CPI weighted average.

Our 5.3 percent CPI inflation projection had forecast that food inflation would rise to 11.6 percent YoY due to cold weather and the earlier timing of the Spring Festival holidays. However, actual food price inflation was only 10.3 percent YoY, which reduced its contribution to overall CPI inflation by a significant 0.42 percentage points (pps) versus our forecast based on the old CPI weighted average. Meanwhile, the rise in residential expenses picked up further to 6.8 percent YoY from 6 percent previously on rising rents, while the increase in medical costs slowed to 3.2 percent from 4 percent.

The National Bureau of Statistics (NBS) also confirmed Tuesday that the anticipated changes in the weighted average of the CPI basket took effect from January. China's CPI weights are revised every five years (minor changes can be made within the five-year periods), based on the 2010 National Household Consumption survey. In particular, the food component was lowered by 2.21 pps, and that of residential (including rents but not property prices) was increased by 4.22 pps. All the other components recorded a reduction in their weight, with medical expenses down 0.36 pps.

However, the changes in the weighted average did not contribute to January's below-consensus CPI inflation figures, nor did they lead to a significant change in the CPI series. There is little difference between the CPI inflation calculated using the new and the old weighted average when you apply either of the two to the official YoY inflation rate of each component over the past year. The NBS only reported the changes in the weighted average of the eight components, but not their actual weight. Our estimates using the old weighted average system yield the same monthly CPI inflation figures as reported officially in 2010.

Looking ahead, we think inflation risks remain significant on the back of the strong growth momentum and upside risks to food price inflation.

Meanwhile, the PPI inflation, which tends to be highly correlated with - even if it does not always lead to - China's CPI inflation, posted a stronger-than-expected 6.6 percent rise in January versus a 5.9 percent rise in December 2010. The continued increase in input costs, reflecting a surge in global commodity prices (e.g., the prices of copper and iron ore posted record highs in January), points to continued upward pressure on downstream inflation.

We maintain our full-year CPI inflation forecast of 4.3 percent and see balanced risks to this forecast (versus upside risks previously). By simply lowering the weighted average of the food component means there will be a lower overall contribution to CPI. The same applies to medical costs. A rise in the weight of residential expenses will add to its contribution to CPI, particularly from the rents component, which saw a surge in recent months. Overall, we are leaving our inflation forecasts unchanged, judging that the upside risks owing to a rise in the weight of the residential-related component will be more than offset by the downside risks stemming from a lower weight given for the food component. This is based on our view of lower and more stable residential expense increases than food price inflation in 2011.

Therefore, forceful government actions to tighten monetary conditions and forward-looking monetary policies to anchor inflation expectations remain warranted. We maintain our monetary policy calls. With nearly 300 billion yuan of bills and notes expected to mature in February and another 700 billion yuan in March, the People's Bank of China (PBoC) will continue to face pressure to withdraw liquidity. We expect another RRR (required reserve ratio) hike - likely this month - to tighten liquidity and control the pace of lending, and expect differentiated RRR hikes to be implemented as a regular monetary policy management tool. We continue to expect the PBoC to front-load its tightening, with two more rate hikes for a total of 50 basis points in the first half of this year. We see the more likely window for the next rate hike being in early April, when the government has gathered information on first quarter GDP growth and March CPI inflation.

The author is vice president and China economist at Barclays Capital Asia Ltd. The opinions expressed here are entirely her own.

(HK Edition 02/16/2011 page2)