China will need to normalize the monetary stance but there is no need to worry too much about inflation


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The recent rise in China’s inflation has grabbed attention of the public and policymakers alike. Consumer price inflation rose to 5.1% in November. This is higher than we are used to in China, although it is modest in an emerging market perspective. To determine the best policy response to the rise in inflation it is important to know its cause and how much inflation we should expect in the coming 12 months. It is also good to decide what an acceptable rate of inflation is for a country like China.

So far, the rise in inflation is because of higher food prices. The food component of the CPI was up 11.7% on a year ago in October, contributing two-thirds of overall inflation, while non-food prices were up 1.9% on this basis. In looking for the cause of the higher food prices, monetarist explanations are common. After the massive monetary expansion since end 2008 there is a lot of liquidity sloshing around, potentially putting upward pressure on prices, especially asset prices. In this setting, there are reports that speculative activity has driven up prices of several food products. It is also true that in the long run sustained monetary expansion drives up inflation. However, the link from money to inflation is more indirect and complex than simplistic monetarist interpretations suggest and, in the meantime, inflation is basically determined on the markets for goods and services.

Several food markets have been buffeted by domestic supply shocks. In particular, vegetable prices, which have seen the largest price rises, have been hit by bad weather and natural disasters. Recent hikes in international food prices have added pressure. China’s rice and wheat prices do not closely follow international prices, since they are managed by policymakers. However, China’s prices of corn and soybeans follow international prices fairly closely and higher prices for these products have helped driving up meat and egg prices in China. Housing-related costs have also contributed. However, prices other than those of food and housing remain contained—they were 0.8% up on a year ago in October.

Inflation is unlikely to escalate but expectations matter and there are risks. Food prices are unlikely to continue to rise at the recent pace. Domestically, the supply side factors driving up prices are considered in large part temporary. Internationally, after the hefty increases in prices of raw commodities such as food and many industrial commodities since early summer, mainstream forecasters do not expect them to continue to increase at this pace. More generally, despite further quantitative easing in the US, global inflation prospects are generally considered modest, largely because of substantial spare capacity in many markets globally. Indeed, the US just registered the lowest rate of core inflation since records began in 1957.

There is some risk that the higher food prices spill over into wages and other prices. This risk is manageable but it requires policy attention. People typically resist real wage declines if they can. Thus, large rises in prices of food or energy are often followed by wage hikes. This can set in motion a wage-price spiral, especially in a low productivity growth environment. In China, price shocks tend to be more easily absorbed than in many other countries because of robust productivity and wage growth, and core inflation is low to start with because of the rapid productivity growth in industry. Nonetheless, with inflation expectations now having risen substantially and the labor market less loose than it used to be, macroeconomic policy will need to play an important role in limiting the spill-over of food prices into other prices and wages.

The risks of inflation and the need to manage inflation expectations strengthen the case for normalizing the monetary stance. Indeed, with little spare capacity in China's economy, respectable growth prospects, and concerns about too rapid housing price increases, this normalization will need to be a central objective of macroeconomic policy. Thus, after the spectacular increase in monetary aggregates since end-2008, monetary growth will before long need to come down to rates broadly similar to nominal growth. Moreover, relying more on interest rates and less on quantitative instruments such as credit controls would help reduce the underlying pressures on asset prices and reduce distortions. In October, the PBC raised benchmark interest rates by 25 basis points. But they are still much lower than before the crisis and they will have to go up more.

Concerns about the impact of financial capital inflows are overdone and are no good reason not to increase interest rates. Thanks to China’s largely effective capital controls, the amount of net financial inflows (called “hot money” in China) is actually very low compared to domestic credit creation. Also, the overwhelming majority of the increase in foreign reserves is not from net financial capital flows but from current account surpluses and net inward FDI. 

However, the inflation outlook does not seem problematic enough to warrant suppressing overall inflation by administrative measures or postponing needed price adjustments. High inflation is distortive and not helpful. However, in rapidly growing countries like China, relative prices need to change to facilitate changes in the economic structure. In most emerging markets moderate inflation—of 4‐5 percent—is not seen as a major problem. Constraining inflation to be very low could hinder helpful relative price changes. For instance, China needs to increase administrative prices for resources and utilities—especially energy and water—to help adjust the structure of the economy. And, higher prices for agricultural products and higher migrant wages can help boost rural incomes and reduce urban‐rural inequality, thus helping to improve the primary income distribution. It would be really unfortunate if such desirable developments were suppressed because of concerns about moderate inflation. Thus, somewhat higher tolerance to modest inflation could help bring about some of the structural reform and change that the government is aiming for.


Louis Kuijs

Macroeconomy - China

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December 25, 2010

"inflation is basically determined on the markets for goods and services"

Commodities inflation is principally determined by speculation on bourses. there is no other explanation if you consider the price of oil going from 147 USD to about 30 USD within a few months. Look at the price of copper trippling in the last year or so for example.

The market for goods is definetly an input but speculation exagerates movements in prices incredibly.

Louis Kuijs
December 26, 2010


Thanks for this comment.

I would also think that, on the international markets for commodities, financial speculation probably plays a role. I would think that the role would especailly be to amplify price movements.

I am not sure whether financial speculation can prop up commodity prices over very long periods.

After the 2007/8 commodity price spike, many empirical studies have tried to estimate the impact of financial speculation. Actually, most empirical studies have had a hard time finding clear evidence of such impact. One likely reason for that is that, despite all the short term noise, often the financial speculation actually reflects fairly rational expectations regarding the real market dynamics.

Joseph Alexander
January 02, 2011

Mr. Kuijs,
I believe that real estate speculation is the source of CPI inflation in China. In 2000 residential real estate sales totaled $48 Billion +- in 2009 this figure grew to $573 Billion +-. In 2000 23% of wages were directed at residential acquisitions in 2009 this figure grew to 59%. Since 2000, residential prices have increased roughly 2.3 X nationally while cities such as Shanghai and Zhejiang experienced price escalation between 2.9 X – 4.5 X. If a significant amount of the populations net worth is real estate and the same asset has appreciated significantly this asset appreciation will either increase the wealth of the country or decrease the value of the currency.
Mr. Kujis, I’m currently writing my thesis on the Chinese real estate market. I would be very interested in talking with an economist familiar with the subject. Two particularities that I’m having difficulty evaluating is the extent of grey market in real estate and SOE’s overall influence in the development industry. Would it be possible to get in touch with either yourself or another economist with expertise in China?

I'm a student at Columbia University in the Masters of Real Estate Development program.


January 05, 2011

It seems like the conversation that we had on this blog in June this year about M2, inflation and supply and demand is back again.

I have a different question this time. You state that”Domestically, the supply side factors driving up prices are considered in large part temporary” could you elaborate a little on this statement?

I ask this because from my point of view the supply side factors do not seem to be temporary.

The rise in inflation has been steady since august and it does not fit an “inflationary freak” of nature pattern were prices suddenly and unexpectedly go up just to fall again when the market allocates capacity. The fact that there were very high inflation numbers in 2007/2008 just before the crisis should tell us that there where capacity issues at that point in the Chinese economical development. Problems not easily fixed.

The food inflation comes from a lack of arable land and a primary agricultural sector that has not been reformed properly because the price of its goods has been held down artificially.

The real estate sector has not been cooled down and as we write prices are still rising in almost all cities in China although at a slower pace. The real estate giant Vanke just posted 108 billion Yuan in sales revenues.

The leaning cap of 2011 will be about 7 trillion Yuan which is almost the same as 2010 so there will an equal amount of inflationary pressure from the M2 again this year.

The excess capacity or released demand you talked about in other parts of the world is, I would argue, mostly in manufacturing and not in demand for food or energy. When a crisis hits then people don’t stop eating or turn down their heating, they first cut back on TVs, Cars and more expendable items…

The crisis does not seem help the Chinese inflation problems in the sense that much of the production capacity in the Chinese export sector cannot produce more food, more energy or more water.

Based on this I think 5.1 % inflation is just the beginning, but I really hope to be wrong as inflation always hits the lower income groups hard especially in China were cash savings are such a large part of private peoples asset holdings.

Louis Kuijs
January 10, 2011


China's real estate market is definitely very active, and parts of it seem pretty frothy, with speculation going on.

Also, real estate speculation and inflation likely have some common contributing factors. The vast amounts of liquidity moving around in China surely add to the real estate speculation, while it must have some impact on prices of goods and servcies as well.

However, in my view real estate speculation is not the cause of CPI inflation. So far, 3/4th of the inflation is because of food prices, with "residence costs" (driving by the rental and utility costs) explaing much of the remainder. Higher energy prices are a key contributor to the increase in residence costs.

In all, the bulk of the inflation driven by specific factors.

I am afraid I have no knowledge or insights in the gray real estate market in China.

Good luck.


Louis Kuijs
January 10, 2011

Anders, thanks for your good comments.

I think the key thing to emphasize about inflation in China is that it is still largely food driven. I agree that China's economy, overall, does not have spare capacity and I also agree that the growth of China's monetary aggragetes will have to slow down to avoid problems along the way. But, with non food inflation still less then 1 %, it is difficult to argue that macro factors have been the most important in driving up inflation.

There are indeed structural factors that drive up agricultural prices over time and the relative price of agricultural products. This has been going on for a long time and is not a problem. In fact, it is an important part of structural change and is a channel to alleviate rural poverty and inequality.

At times, we see a sudden acceleration in food price increases. They regularly coincide with global food price pressures, but also often seem to have domestic causes. We seem to be in such a phase again. Bad weather and disasters have affected harvests and food supply, and most experts emphasize the temporary aspect of much of this. In the background, the structural factors continue to drive up agricultural prices gradually. But food price increases are likely to slow from the really rapid food price increases seen in August-November 2010. Indeed, recent information suggests vegetable prices--key this time around--seem to have plateaued for now.

Note that there is no need for food price levels to fall. As long as the pace of increases in food prices declines again sooner rather than later--and before spill over into other prices and wages takes off--overall inflation should likely slow again.

On global factors, I agree that the "excess capacity globally" that I referred to is largely in manufacturing. However, my collegues who look at primary commodity markets and their peers in the private sector tell me that oil and other important markets "continue to be well supplied" and they do not expect a major run off of primary commodity prices. They could well be wrong. And China would feel more inflation pressure in a scenario with more global commodity price pressure. But that is a different scenario, with inflation a global issue.

In all, in my base scenario for China the speed of increases in food prices is diminishing and overall inflation will not escalate.

January 26, 2011

Hello Louis,

I love to read your articles and find them inspiring.

Besides what you have talked about the possible factors influencing the food price hiking, a factor of 'circulation cost ' (or Transaction cost ' )of the agricultural produces to the market should not be under estimated.

These factor is playing a key role in adding the cost from the filed to the shelves in the supermarkets of these foods and groceries. Based on my experience in business journalism, I think it is necessary for the government to address the concerns about the such transaction cost, such as overly high fee the toll roads.

Such actions will make a difference in dampening the price spike in China nowadays.

Louis Kuijs
January 31, 2011

Hi Liang, thank you for the kind words.

I agree, there are a lot of cost factors that matter for the price of food other than what goes to farmers and, indeed, transportation costs, notably toll, are important.

In normal circumstances, such costs do not really explain the increase in the rate of food price inflation. But reducing such costs can indeed help contain inflation.

As a matter of fact, as part of a package of measures to contain food price inflation, China's government in November 2010 exempted the transportation of "fresh produce" (mainly fruit and vegetables) from toll.

This type of measure is not included in most textbooks. And, relying on such measures typically introduces distortions (will the road operating entities be compensated for the loss of income?). But it may help tone down pressures in the short run and it most likely has helped contain inflation expectations.

February 22, 2011


Sharp column as normal.

I agree with you that we dont need to worry to much now about the chinese inflation, yet, mainly because of the food driven characteristic. For those of us whom live in China, calls the attention the increase of rentals o wages, said that.

In you opinion, when should be worry about the chinese inflation?