Inflation - Pick-up in upstream inflation broadly in line with expectations: Producer and raw materials purchasing price indices both reclaimed positive YoY gains in December, broadly in line with our expectations. PPI rose 1.7% YoY (-2.1% in Nov), while RMPPI gained 3% (-3.6% in Nov). On a MoM seasonally-adjusted basis, both indices sustained sequential gains, by 1.8% (+0.9% in Nov) and 2.1% (+1% in Nov) respectively. The uptick was driven primarily by the jump in energy prices due to the low base effect. The faster-than expected turnaround upstream prices and the rapid monetary expansion last year are fuelling fears for high inflation this year. Given the approximately six-month lag effect of accommodative monetary conditions in 2009, the key swing factor in determining inflation is how fast the output gap will close, which is a function of export growth rate (see our report Worried About Inflation? Get Money Right First, dated October 20, 2009).

… while higher-than-expected consumer inflation is attributable entirely to food: CPI inflation picked up to 1.9% YoY in December, beating our and market forecasts (+1.4%). Nevertheless, the upside surprise stemmed entirely from the food component (+5.3% YoY, vs our forecast of +3.7%), while non-food inflation still fell below expectations (+0.2% vs our forecast of +0.6%). On a seasonally-adjusted basis, consumer prices rose 0.7% MoM (+0.4% in Nov), the biggest climb since November 2007. The uptick in the final month of the year narrowed full-year CPI deflation to 0.7%, marginally milder than our forecast (0.8%).

David Fuller's view China may now be the world's second largest economy and it is also booming, although income per capita is still much lower than in the West. Consequently, any inflationary surge and particularly higher food prices will trigger a quick response from monetary authorities.

But is commodity inflation a problem in China today? China's data for December did show a surge higher, but from minus levels which has persisted for a number of months (see the two graphs on page 21 of the Morgan Stanley report above). If prices in China continue to rise at their December rate, then the squeeze is on, but will they?

For further and more up-to-date information, look at these weekly charts of the DJ UBS Petroleum Index and the DJ UBS Grains Index. The Petroleum Index does have a recovery bias but it remains very rangy and has weakened recently. Crucially, it is nowhere near its 2008 peak. The Grains Index is probably base building but it too is well beneath its 2008 peaks and has yet to establish an upward trend.

My conclusion from this and other data - with a booming economy China is right to adjust monetary policy early and incrementally. However, with loan demand now very likely to decline there is little evidence that a sustained squeeze is required. Nevertheless China's stock market (weekly & daily) retreated further today and although looking somewhat overstretched, an upward dynamic is still required to indicate that bulls are regaining the upward hand.