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BEIJING (Reuters) - China must set economic policies to avoid the risk of deflation spreading to consumers from producers and creating a spiral of souring business expectations that would lead to job cuts, a senior official at a top government think-tank told Reuters.
Chen Dongqi, deputy chief at the Academy of Macroeconomics Research, said downward pressures were so strong that the downdraft on China's economy may extend beyond the third quarter of the year without firm policy action.
"If the government intensifies the strength of prudent and moderately loose monetary policy, China's economy might hit a bottom in the third quarter," said Chen.
"In particular we should prevent producer deflation from expanding to the consumer area in the second half of 2012," said Chen, whose think-tank feeds into China's top economic planning body, the National Development and Reform Commission.
"Once deflation happens in consumer prices, we would pay a big price for policy changes to solve the problem."
Chen called for a 50 basis point cut to borrowing costs and a further 150 basis points to be cut from banks' required reserve ratios this year - in addition to the 150 bps already cut that has freed an estimated 1.2 trillion yuan (122 billion pounds) for lending to support economic growth.
The risk of a further deterioration of domestic demand that could drag down the broad economy for the remainder of the year is crucial for China's ruling Communist Party as it prepares for a once-a-decade leadership transition, scheduled for the autumn.
The showpiece event means the government is determined to ensure it takes place against a backdrop of social stability and economic prosperity.
China's economy though is on course for its slowest full year of growth since 1999's 7.6 percent annual expansion and data last week showed GDP growth had slowed for a sixth successive quarter in the second quarter to 7.6 percent, its slackest pace in more than three years and only just above the government's 7.5 percent target for 2012.
China last suffered a bout of deflation between February and October of 2009. By the end of 2009, consumer prices had fallen 0.7 percent on the year.
During that episode annual GDP growth sank to an 8-year low of 6.6 percent in the first three months of 2009 as deflation began to get a grip, with the economy overall seeing its slowest full year of growth since 2002 - albeit at a 9.2 percent clip.
Inflation had been the government's main preoccupation until recently, with policies set to bring it down from the three-year high of 6.5 percent hit in July 2011 and back below the official annual target of 4 percent.
Chen said he expected the annual rate of consumer inflation to fall below 2 percent in every single month in the second half of 2012, pulling the full year rate down to 2.5-2.6 percent.
A slowing economy pushed down China's annual consumer price inflation to a 29-month low of 2.2 percent in June, and producer prices fell 2.1 percent from a year earlier - a fourth straight month of outright deflation at factory gates.
"If we do not intensify the strength of prudent and moderately loose monetary policy, companies' downward expectations on the economy will grow and that will make them cut staff," Chen said.
Chen said firms are delaying jobs cuts in a bid to avoid a repeat of their experience in the wake of the 2008/09 global financial crisis, when heavy lay-offs left them woefully short of skilled staff when the economy began a rapid rebound.
Jobs are a crucial variable for China's stability-obsessed government, especially ahead of the leadership reshuffle.
Chinese firms slashed some 20 million jobs in the final months of 2008 as global trade flows - to which the world's second biggest economy is heavily exposed - ground to a halt.
Chen said firms were cutting wages rather than staff, but that could dent spending power and restrain retail sales, seeing growth ease to 12-13 percent for the full year, down from a 14.4 percent rate in the first half.
"It would be lucky if retail sales could maintain double digit growth on average in the second half of 2012," he said.
"There could be large-scale lay-offs by companies in the second half if their orders and profits decline as they don't have an optimistic business outlook. This in turn could affect income expectations and consumption," Chen said.
Reporting By Xiaoyi Shao, Shen Yan and Kevin Yao; Editing by Nick Edwards