Warning: Inflationary pressures to run high for a while longer

Although July’s CPI print came in below market and our expectations, inflationary pressures are still hovering at elevated 2008-peak levels. The recent cooling of global food and commodity prices means that headline inflation has started to normalize, but the decline is proving to be very sticky. Core inflation should start to ease as well, soon, in response. Surprisingly, so far, there's little evidence that rising prices have undermined household purchasing power. Still, the risk remains that ultimately consumers may eventually cave in the face of rising prices.

Facts
Inflation in Hong Kong showed no meaningful signs of a cool down in July, as CPI rose 7.9 % y-o-y (vs. 5.6% y-o-y in June). This was less than both our and market's expectation of 9.0% and 8.2% y-o-y, respectively. A large unfavorable low-base effect caused by the introduction of a three-month public housing rental waiver in July last year was countered by a sharp drop in utility prices last month. Cooling of global food and commodity prices saw utility prices contract 16% y-o-y in July after having risen by 8.2% in June.

The top contributors to inflation were once again housing rental and food prices, which added 5.2 percentage points and 2 ppt to headline CPI respectively.

Stripping out the impact of one-off government measures, the underlying inflation rate accelerated to 5.8% y-o-y from 5.5% previously. Likewise, core inflation (excluding utilities, food and transport costs) picked up pace to rise 9.5%, compared to 5.5% a month earlier.

As the underlying and core rates of inflation suggest, the low base effect created by last year's rental waiver was not to be solely blamed. Significant increases in pork prices (which track Mainland pork prices extremely closely) and charges for package tours were also flagged as key CPI drivers in the Census & Statistics Department's press release.

Overall food price growth accelerated to 7.4% y-o-y from 7.0%. Seasonally adjusted we estimate that it rose 0.6% on the month seasonally adjusted, faster than the 0.4% pace recorded in June. Housing costs jumped sharply to rise 16.4% y-o-y compared to 6.5% previously. Seasonally adjusted, the m-o-m growth rate of overall housing costs printed 0.4% again, same as a month earlier.

Implications
The question on everyone's mind right now is - with Hong Kong's headline inflation hitting a post-1995 high on a y-o-y basis, is the economy sailing into runaway territory? In a word, no.

CPI growth momentum is best tracked according to the sequential annualized growth rate. On this basis, we are not in unchartered territory. As chart 1 shows, although both headline and core inflation are indeed sitting at very elevated levels, Hong Kong has been here before. On a %3m/3m, saar basis, headline and core inflation printed 6.2% and 8.6% respectively last month, compared to their respective peaks of 6.9% (June 2010) and 10.5% (January 2011) in the 2008-2009 period.

More importantly, on a sequential annualized basis, headline CPI inflation appears to be normalizing, although the decline has been uncharacteristically slow. Provided this trend continues, core CPI inflation should similarly peak out (on the same basis) in another 1-2 months' time. That said, its pace of decline will likely also be extremely sticky.

So far there's little evidence that rising prices have undermined household purchasing power, and as Hong Kong's real retail sales numbers attest, consumers have been rebuffing the erosive effect of rising prices on their wallets. On a sequential annualized basis, real retail sales (one of the closest proxies for Hong Kong's real private consumption) is still expanding at roughly the same average 25% pace as in 2Q11.

Although consumers have yet to rein back in their spending, if inflationary pressures remain as stubbornly sticky for the rest of Q3, chances are that consumers may eventually cave in the face of rising prices.

With consumers in the US and EU looking increasingly strained, Hong Kong's exports growth driver is set to be weaker in 2H11 relative to 1H11. If inflation refuses to normalize at a faster pace, then Hong Kong's second key driver of growth - being domestic consumption - could start turning wobbly before the year is up. Ironically, such an outcome could be just the prescription that's needed to bring inflation back down to earth, and for the economy to strike a more healthy macroeconomic balance. Of course, real GDP growth in such a scenario would be slower than the 6.4% we have currently penciled in.

Bottom line: The lagged transmission of last year's property price increases and a weaker USD will continue to fan Hong Kong's inflation for the second half of this year, but Mainland food price inflation should stabilize going into Q4 if Beijing's measures go according to plan. Putting cyclical issues aside however, structurally, the economy is running at close to (or over) full capacity. So unless households start to react to rising prices and rein back in spending, inflationary pressures will likely run high for a while longer. Ultimately, something will have to give first, if the territory is to strike a healthier macroeconomic balance.