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Food for thought: China's inflation

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18 May 2011 09:00

China's inflation reached 5.3% in the year to April, down a little from the peak recorded in March, but still well above the authorities' objective of 4%.

Market commentary tends to treat this in the same way as inflation in Western countries, asking when Beijing will tighten monetary policy. But for the Chinese authorities, inflation presents a more complex and broader set of issues.

Is 5% too high? It is well above the 2-3% which is so often the formal target for Western central banks. It is higher, even, than the IMF Chief Economist's view that 4% might be a better inflation target for emerging countries. The core underlying rate (ie. excluding volatile items) is running around twice as fast as has been customary in China over the past decade. Consumer price expectations are rising higher.

There is no way the authorities would risk a sharp rise in price expectations that might lead to the 25% inflation experienced in the mid-1990s. Thus China will want to slow the economy a little from its current 10% growth rate. Does it have the instruments to do this? 

China's financial authorities have an array of instruments at their disposal that might be the envy of Western central banks, confined as they are to the market-friendly tool of interest rate increases.

The Chinese have much more direct control over interest rates (both lending and deposit rates). Open-market operations are used in ways familiar to their Western counterparts, but Chinese authorities also have credit-growth targets (which they can enforce through strong suasion) and they are currently sterilising one-fifth of bank balance sheets by requiring banks to place low-interest reserve deposits at the central bank. Less subtle still, they can decree price freezes and pressure producers to keep price increases low.

Effective as these direct controls are, they are crude, with none of the Delphic subtlety beloved of Western central banks. They inhibit the development of a responsive financial sector, allocate credit inefficiently, and entirely miss the shadow financial sector, which is probably as big again as the formal one.

There are also political constraints on setting the instruments: lending rates are barely positive in real terms, distorting investment. Deposit rates are so low as to give savers an incentive to speculate in real assets such as housing and equities. Thus there is always some danger of over-doing things and causing a hard landing. But this seems a low probability.

The 11.5% increase in food prices over the past year would be of more concern to Beijing than the overall inflation index. As was demonstrated in Egypt, food price rises are the stuff of revolutions. Food makes up one third of China's inflation index, twice the weight typical in Western indices, though even this high weight would not adequately reflect the importance of food in the consumption basket of the vast bulk of the poorer Chinese population. 

The usual instruments of monetary policy are of little use here. Food prices are not just a matter of macro-economic management, but a political priority with no clear counterpart in Western economies.

If food and other essential prices can be held in check (and supply is the dominant factor here, not monetary policy), inflation of around 5% may not be such a bad outcome. There is time to fine tune the crude instruments of macro-policy (especially removing the huge fiscal boost administered during the Global Financial Crisis). Inflation at this pace might help to placate US demands for exchange rate appreciation (inflation appreciates the exchange rate in real terms). Productivity improvements and modest wage rises mean that this can be achieved without dramatic loss of international competitiveness.

This kind of 'crossing the river by feeling the stones' seems much more in keeping with the Chinese approach to economic policy than any drastic response to US pressure for a substantial nominal exchange rate increase, no matter how helpful this might be for inflation.

Photo by Flickr user foxxyz.

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