Chart 1 shows China’s official year-on-year (y/y) rate of CPI inflation (6.4% in June)， as well as what the figure would be if pork prices are excluded (4.7%). In short， the recent increase in y/y pork prices is one of the main factors driving up official CPI. Pork accounts for about 10% of the approximately 30% weighting of food in the CPI basket， which means that pork accounted for an extraordinary 27% of June’s 6.4% CPI inflation reading， according to our calculations.

Being kidnapped by pigs is not a pleasant experience for anybody. Premier Wen was in Shaanxi Province recently visiting a farmers’ market. He encouraged local officials to support pig production， and to take action to cut costs in the pig-supply chain. The State Council has also announced measures to continue with subsidies for largescale farms， as well as support for vaccinations. But such measures will have limited impact in the short-term， and run the risk of exacerbating the cycle. In 2008， facing high pork prices， the government offered subsidies. Farmers jumped into pig farming， and when the subsequent supply wave crushed prices， many sold or killed their pigs. Today’s consumers are living with the consequences of that policy – China’s farms produced only 24mn tonnes of pork in H1-2011， 0.5% less than in H1- 2010. Now， higher pork prices are likely again inducing farmers to raise more pigs(indeed， China could well see another pig glut in H2-2012， even without subsidies， which this time appear targeted at commercial farmers). Unfortunately， in the short-run， policy makers have to wait for that supply to hit markets.

Why are pork prices flying? Pig diseases alone are not to blame (an outbreak of gastroenteritis killed some of the livestock late last year)， nor are inefficiencies in the supply chain. Pork prices， like other food prices， are a sensitive indicator of the broader economic cycle， we believe. And many macro factors are still pushing prices up.

On the demand side， rural household spending rose 16.2% y/y in H1-2011， according to the National Bureau of Statistics， and it is the rural sector that provides the marginal demand for meat.

On the supply side， feed prices are still rising. Household pigs often eat a mix of food from the kitchen; factoryfarmed pigs eat pig feed， a mix of corn and soy. Corn prices are rising at a steady 20% y/y rate， as Chart 2 shows， and show no signs of stabilising. Fuel and transport costs are rising too， at a rate of 14% y/y. However， as Chart 4 shows， assuming the global oil price does not increase from here and China does not hike product prices again， diesel inflation should recede by year-end.

Labour costs for migrant workers are also rising， by some 10-15% y/y. The volatility of pork prices has also dissuaded many rural households from farming pigs. Commercial farms now own an ever-bigger share of the herd， and they should become better at managing the pigfarming cycle as they gain experience.

Clearly， though， pork prices are rising faster than input prices. The squeeze that farmers felt in mid-2010 between low pork prices and high corn prices， which Chart 3 shows， pushed many farmers to sell their herds. The disease outbreak in late 2010 did not help， either. But pig-farming is now profitable – farmers have probably broken even since Q3-2010. So supply response is already in the pipeline.

However， it is a fairly long pipe. The full supply cycle lasts 12 months; three months for a female piglet to grow into a sow， a four-month pregnancy， and then another five to six months to feed the piglets until they reach a weight of up to 100kg. The supply response should start to hit in July-August， we think. We think that the recent acceleration of price increases will lose some steam and that y/y growth in pork prices should plateau in August.

In Beijing’s Xinfadi market， pork prices in the last two weeks have already shown signs of stabilising， as Chart 5 shows. Nationwide marble pork (五花肉) prices rose 1.7% to CNY 30.24 (USD 4.7) in the first ten days of July from end-June， according to the National Bureau of Statistics. We expect pork prices to rise around 53% y/y in July， marginally lower than the 66% y/y in June. We still believe CPI inflation will peak out in June/July， then fall from August.

The State Council will probably release a document soon to explain its priorities for economic work in H2-2011; it appears to have held its main economic work meeting on Tuesday. Based on comments by Premier Wen earlier this week， we expect it to say that the State Council will continue its “prudent” (穩(wěn)健) monetary policy， but will likely qualify its inflation-fighting stance by emphasising the need for policy to remain “directed， flexible and forward-looking”. This language is less forceful than in past statements， and leaves open the possibility of policy adjustments after the official CPI peaks (in June or July， we expect)， and the economy shows further signs of slowing.