China's consumer price index (CPI) will likely peak at 5.9 percent year-on-year in June before softening from the third quarter onwards due to the moderating base effect in the second half.

For the month of May, I have forecast a CPI reading of 5.5 percent (all on a year-on-year basis unless otherwise indicated), up from 5.3 percent in April on the combined effect of a 12.2 percent increase in food prices and a 2.6 percent rise in non-food prices during the month.

The jump in food prices is attributable to the rebound in vegetable and pork prices after a devastating drought hit the southern provinces where major agricultural production bases are located.

Prices of agricultural products picked up in May as reflected by a 3 percent month-on-month increase in the agricultural product price index, fueled by the continued strength in vegetable and pork prices.

Meanwhile, declining international commodity prices may have helped ease the growth in non-food prices. This is echoed by an expected moderation in the PPI, from 6.8 percent in April to 6.4 percent in May, which is in line with a 5.9 percentage point fall in input price PMI to 60.3 percent during the same month.

Based on the CPI forecasts for May and June, I believe that a rate hike of 25 basis points by the People's Bank of China in June is highly likely. And I do not rule out the possibility of another round of reserve requirement ratio increases in June as the central bank is still concerned about liquidity flows.

In light of recent food and non-food price trends, I have raised the CPI forecast for 2011 to 4.9 percent from the 4.5 percent estimated previously.

The revision is mainly in order to reflect the recent rebound in agricultural product prices after the severe droughts that hit southern China.

However, agricultural product prices should stabilize in the third quarter.

Despite the droughts in the southern provinces, the Ministry of Agriculture estimates that grain production (mainly wheat) from the summer harvest is likely to increase 2 to 3 percent this year given that most wheat production is located in the northern provinces. I believe the summer grain harvest will help stabilize prices of major grain products in the second half of this year. Stabilized corn prices and an increase in pork output will lead to a moderation in pork prices in the third quarter.

The CPI is expected to demonstrate a downtrend in the second half year. Based on my updated forecast model, the CPI will peak at 5.9 percent in June, averaging 5.5 percent in the second quarter. It will decline to 4.9 percent in the third quarter and fall further to 4.2 percent in the fourth quarter, largely due to the moderating base and the lag effect of credit tightening.

With the CPI moderating to below 5.0 percent in the third quarter, the authorities are expected to shift their policy focus to stabilizing economic growth subtly from the middle of the third quarter.

The author is an associate director and economist at CCB International Securities Ltd. The opinions expressed here are entirely his own.

(HK Edition 06/14/2011 page2)