China needs healthy inflation, not simply higher prices, economist warns

Zhiheng Luo, Chief Economist at Yuekai Securities, said rising crude prices may lift China's inflation readings, but imported cost pressures are no substitute for a genuine demand-led rebound.

In China's 2026 Government Work Report, policymakers made an explicit point:

steering general price levels back into positive territory and produce a reasonable, modest rebound in consumer prices

推动价格总水平由负转正、消费价格合理温和回升

Now, with the Iran crisis driving oil sharply higher and Brent moving above $100 a barrel, headline inflation in China could rise with it.

But that would be the wrong read, according to Zhiheng Luo(罗志恒), Chief Economist at Yuekai Securities. A higher CPI driven by oil is not proof that consumption has revived, that deflation is over, or that policy should turn tighter. It may simply mean that demand is still weak while costs are rising first.

That distinction matters. The inflation China needs is the healthy kind: driven by stronger demand, firmer incomes, improving profits, and restored confidence. The inflation it does not need is the kind imported by geopolitics, one that makes petrol dearer, raises logistics costs, squeezes households and firms, and muddies the policy signal without delivering a real recovery underneath.

That is why the upcoming inflation data will need to be read with care. In his latest essay, Luo bluntly warns against confusing the two, and against mistaking an oil shock for the start of a genuine recovery.

His piece was first published on Yuekai Securities's WeChat account on March 12. Please note that the translation below is mine and has not been reviewed by him.

Luo Zhiheng: What China needs is not inflation itself, but the virtuous economic cycle behind it

罗志恒：我们需要的不是通胀本身，而是通胀背后的经济良性循环

Recently, tensions in the Middle East have escalated abruptly, triggering sharp swings in international oil prices. During trading on March 12, Brent crude once again climbed above $100 a barrel.

A surge in oil prices will inevitably feed through into China's domestic PPI and CPI. Based on historical estimates, every 10% year-on-year increase in oil prices may lift China's PPI and CPI by 0.4 and 0.1 percentage points respectively. (For details, see my previous piece "Different Roads, Different Destinations — Can Higher Oil Prices Help Push Prices Back to a Reasonable Recovery?")

At first glance, this may seem to align neatly with the policy direction set out in the 2026 Government Work Report: "to steer general price levels back into positive territory and produce a reasonable, modest rebound in consumer prices."

But one point must be made clear: oil-driven price increases are by no means the same as a "modest rebound in consumer prices." Inflation for its own sake is not the goal. It is essential to weigh the pros and cons, to distinguish between "good inflation" and "bad inflation", and to separate "demand-driven inflation" from "cost-push inflation", while preparing policy responses in advance.

I. The meaning of macro policy targets lies not in the numbers themselves, but in the real conditions of the micro-level actors those numbers represent

The 2026 growth target of 4.5%–5% is not about piling up output through inefficient investment or unwanted inventories. What it seeks is a genuine revival of the economy's internal cycle, in which firms expand investment voluntarily and households are willing to spend more.

By the same logic, the inflation target of around 2% is not about simply pushing prices higher. It is about using mild inflation to break the vicious cycle of "sluggish prices → delayed consumption and investment → weak economic activity", so that improving corporate profits and rising household incomes can become a sustainable norm.

In other words, what is needed is not "inflation" in itself, but the underlying logic of a normally functioning economy that inflation can reflect. The core goal of policy is to rebuild and preserve a complete incentive mechanism in which firms can make profits, households have jobs and income, and society has confidence in the future.

II. The source of inflation matters: "good inflation" and "bad inflation" are fundamentally different

It is necessary to distinguish between different sources of inflation. What China does not need is stagflation driven by supply shortages, runaway inflation caused by excessive money creation, or structural bubbles in which asset prices soar while the real economy remains flat. What is truly desirable is a moderate rise in prices driven by stronger demand.

Prices pushed up by supply contraction are not a sign of economic improvement. More often, the result is stagflation: prices rise, but the economy deteriorates further. Prices driven up by excessive money creation may create the illusion of prosperity in the short term, but in the long run they end in runaway inflation and costly wealth redistribution. Structural bubbles, in which asset prices surge while the real economy stands still, only worsen inequality and build up financial risks.

A moderate, demand-driven rise in prices is entirely different. Stronger demand encourages firms to expand production. Better corporate profitability helps stabilize employment and household incomes. Restored confidence among businesses and households, in turn, supports further consumption and investment. In this virtuous cycle, a moderate rise in prices is not something artificially engineered by policy, but a natural outcome of the economy returning to healthy operation. That is the true meaning of "steering general price levels back into positive territory and produce a reasonable, modest rebound in consumer prices."

An oil-driven rebound in the year-on-year growth rates of PPI and CPI may appear to match the policy objective of "produce a reasonable, modest rebound in consumer prices", but in reality there is a clear mismatch. The current weakness in domestic prices is mainly the result of insufficient effective demand. The type of price recovery policymakers want is "demand-driven inflation", whereas the inflation caused by rising oil prices is "cost-push inflation" or "imported inflation", stemming from a supply shock. Oil-driven price increases would bring four main adverse effects.

First, cost-push inflation raises households' cost of living, with the greatest impact falling on low- and middle-income groups. Even when prices rise in both cases, demand-driven inflation is often accompanied by higher household incomes, which provides some offset to the impact on living standards.

Cost-push inflation, by contrast, directly raises living costs, making the pain felt by households more immediate. Energy and food account for a relatively large share of spending among low-income households. When higher oil prices push up transport costs and food prices (through agricultural inputs and logistics), they erode the real purchasing power of lower-income groups even more sharply.

Second, firms in the midstream and downstream sectors may face a double squeeze from rising input costs and weak final demand, leading to lower profits and weaker expectations. Higher oil prices pass down the industrial chain, raising transport costs, chemical feedstock costs, and agricultural production costs across the board.

Yet against a backdrop of weak end demand, midstream and downstream firms often struggle to pass these higher costs on to consumers. The result is further pressure on profit margins. Even if some of the costs are ultimately passed through to consumers, weak household income expectations and fragile consumer confidence would further suppress demand, which would also hurt corporate revenues and profits.

Third, imported inflation would weaken China's terms of trade, increase pressure on foreign exchange outflows, and work against Renminbi stability. Terms of trade refer to the relative price of a country's exports in terms of imports, measuring how many imports can be obtained per unit of exports and reflecting the overall quality and efficiency of external trade.

China is one of the world's largest crude oil importers, with imports reaching 580 million tonnes in 2025. If oil prices rise and import prices increase, China's terms of trade deteriorate. That means the country must consume more domestic resources and export more goods just to maintain the same level of imports. At the same time, higher oil prices would significantly raise the cost of energy imports, add pressure to the current account, and pose potential challenges to foreign exchange reserves and exchange-rate stability.

Fourth, inflation driven by a supply shock could constrain further monetary easing aimed at supporting growth. The foundations of the current recovery remain fragile, and the economy still needs support from a moderately accommodative monetary policy. Markets have high expectations for further cuts in the reserve requirement ratio and interest rates.

But if higher oil prices push CPI noticeably higher year on year, especially once it moves above 2%, the central bank may face greater public pressure and communication costs when easing policy, as it would also need to demonstrate its commitment to price stability. That would make monetary operations more complex and difficult, and could interfere with the normal functioning of macroeconomic management.

III. Against a backdrop of subdued prices, imported inflation may bring some unintended benefits

In earlier periods, when China's inflation center was relatively high, imported inflation from rising oil prices and similar shocks usually represented an unwelcome negative blow. In particular, once it combined with the "hog cycle", the resonance between hog and oil prices could drive inflation sharply higher. But under current conditions of persistently weak prices, imported inflation may produce some accidental benefits.

First, it may lift inflation expectations and ease the self-reinforcing dynamics of prolonged price weakness. In recent years, prices in China have remained subdued. The GDP deflator has been negative year on year for 11 consecutive quarters, PPI has been negative for 41 consecutive months, and CPI has remained well below the 2% inflation target. As a result, inflation expectations among micro-level actors have stayed low. Once such expectations become entrenched, firms delay investment and consumers postpone purchases, which further suppresses demand and makes it even harder for prices to recover effectively.

Even if the rise in PPI and CPI caused by higher oil prices is not, in essence, a sign of stronger demand, it can still interrupt this self-fulfilling process to some extent and reinforce the policy effect of promoting a reasonable recovery in prices. Japan's emergence from the deflationary malaise that followed the bursting of its early-1990s bubble was, to some extent, also helped by imported inflation pressures generated by pandemic-era global supply-chain tensions and the sharp depreciation of the yen in recent years, which objectively lifted household inflation expectations.

Second, it may improve conditions for upstream firms and reduce real interest rates. Although cost-push inflation may hurt midstream and downstream industries, it can also help upstream sectors such as energy and chemicals stabilize earlier, improving corporate profits and workers' incomes and injecting some momentum into a healthier economic cycle.

In addition, a year-on-year rise in PPI helps lower real interest rates (nominal interest rates minus inflation), easing the debt burden on firms and supporting credit demand and investment.

Third, it may boost fiscal revenues, ease local government debt pressure, and create more room for fiscal policy. On the one hand, tax revenues such as value-added tax and resource tax are closely linked to the price level. A rebound in PPI means a broader tax base in industrial transactions, which can help increase fiscal revenue.

On the other hand, higher prices raise nominal GDP growth, which helps improve local government debt ratio indicators (debt/GDP), easing debt pressure and creating more room for an proactive fiscal policy.

IV. Policy response: do not be misled by surface-level data; act in coordination through supply-side cushioning, relief for micro-level actors, and firm macro policy resolve

First, energy security should be strengthened on the supply side to smooth the domestic impact of volatile international oil prices. One approach is to use strategic petroleum reserves flexibly: increase stockpiling when oil prices are relatively low, and release reserves into the market when prices spike sharply, so as to play a stabilizing role by shaving peaks and filling troughs.

Another is to make full use of the buffering function built into the refined-oil pricing mechanism. China's current pricing system includes arrangements such as a "ceiling price". When international oil prices rise above $130 a barrel, domestic refined-oil prices no longer rise in step. In extreme circumstances, this mechanism can weaken the transmission of global oil prices to domestic end-user prices.

A third is to accelerate diversification of energy import sources and the development of alternative energy. This includes expanding energy cooperation with Russia, Central Asia, Africa, and South America; speeding up the installation of wind and solar capacity and energy storage; and advancing electrification in transport, all of which would reduce the economy's sensitivity to international oil-price shocks.

Second, targeted relief and subsidies should be provided to firms and households in order to stabilize market entities and protect basic living standards. For the hardest-hit midstream and downstream industries and small and medium-sized firms, targeted support should be introduced. Higher oil prices hit sectors such as transport, logistics, downstream chemicals, and agriculture most directly. It would be worth considering temporary tax and fee reductions for these industries, or helping them through periods of elevated costs through special subsidies and interest subsidies on loans, so as to prevent widespread business distress and unemployment.

Low- and middle-income groups should also receive targeted support. Rising energy and food prices have a clearly regressive effect and hit low-income households the hardest. Policymakers could consider raising minimum livelihood support standards in a timely manner and issuing one-off price subsidies or consumption vouchers. This would both protect the social safety net and quickly convert fiscal support into consumer demand through groups with a relatively high marginal propensity to consume.

Finally, macro policy should maintain strategic resolve, pay close attention to core CPI and the output gap, and strengthen expectation management. In the face of supply shocks such as rising oil prices, monetary policy should not respond too early with tightening, so long as the shock is temporary and does not trigger a "wage-price" spiral.

At present, the main contradiction facing China's economy is still insufficient effective demand. The central task of monetary policy therefore remains keeping liquidity ample, ensuring that overall financing costs stay low, and stepping up support for key areas such as expanding domestic demand, technological innovation, and small and micro-sized businesses.

At the same time, the relevant authorities need to strengthen expectation management and prevent markets or the public from misreading the data and policy signals.

For example, when publishing CPI and PPI data, statistical authorities could place greater emphasis on the trend in core CPI to help the market interpret price conditions more accurately. The central bank could also use channels such as monetary policy implementation reports and press conferences to make it clear that "the current recovery in prices is mainly driven by external supply shocks and does not alter the moderately accommodative stance of monetary policy." That would help stabilize expectations and prevent unnecessary suspicion and volatility in financial markets over the policy direction.