China's inflation at both the consumer and producer levels will ease further and the economy could see deflation early next year, Merrill Lynch said in a research note yesterday.

Data released yesterday showed the consumer price index (CPI),the main gauge of inflation, had fallen to 2.4 percent annually in November. The reading was the smallest rise since January 2007 and down from 4 percent in October.

"We expect the CPI to drop to about 1.2 percent in December and become negative no later than February 2009," Merrill Lynch economists headed by Ting Lu wrote in the note.

Merrill Lynch also expected the producer price index (PPI) to move into negative territory before the CPI. The rate of increase in factory-gate prices slowed sharply to 2 percent last month from6.6 percent in October.

The investment bank said the PPI could fall further on weakened demand for commodities, energy and other producer goods. Some of the decline would reflect high year-earlier base prices.

Falling inflation leaves the government more room to implement the "moderately loose" monetary policy and to step up fiscal stimulus, it stated.

Merrill Lynch forecast the People's Bank of China (PBOC, the central bank) would cut the benchmark one-year deposit and loan rates by another 1.08 percentage points before mid-2009, an upward revision from an earlier forecast of 0.54 percentage points.

The loan rate could even be cut by as much as 1.62 percentage points, it said. Given the situation, the PBOC would likely reduce the business tax for banks to compensate for the squeezed interest margin.

The PBOC has cut the one-year loan rate four times since mid-September, with the latest reduction by 1.08 percentage points, in a bid to stimulate the economy. It also has cut the deposit rate three times.

Merrill Lynch also said it expected another 2.5 to 3 percentage points reductions in the reserve requirement ratio by mid-2009.