As China’s economy seems to be recovering, many people here have expressed concerns about inflation. I was able to air my views on the subject in an Op-Ed in China’s main English language newspaper, the China Daily, together with two other experts.
In motivating their concerns on inflation, people cite the unprecedented fiscal and monetary stimulus in many countries to combat the global economic crisis, China’s own large-scale stimulus measures, or recent increases in prices of several food items as possible reasons. In my view we do not have to worry about inflation for now. There is simply too much spare capacity across the world. However, the very loose monetary conditions in China can cause other damage if left unchecked for too long. It makes sense to try to avoid future asset price bubbles and problems for banks’ balance sheets.
Ample spare capacity globally makes inflation unlikely any time soon. According to Milton Friedman, “inflation is always and everywhere a monetary phenomenon.” However, in reality the link between money and inflation is very complex and not so obvious. That is why central banks in most high-income countries now base their monetary policy decisions largely on the balance between demand and supply in the markets for goods and services instead of monetary aggregates. At the moment, spare capacity is high in many parts of the global economy. The OECD estimates that in the high-income countries the economy wide “output gap” will average 5 percent this year, and in China it is also sizeable. This is why international prices of manufactured goods are expected to fall 5 percent (yoy) in US dollar terms this year. Given the subdued global growth prospects, it will take quite a while to remove the slack.
Moreover, the monetary expansions in the US and other high-income countries are at the moment much smaller than many people think. Banks there have used the liquidity injections to restore their reserves, and the unprecedented measures are taken to avoid a credit crunch. It is once economic growth and bank lending comes on stream again that banks could lend out multiples of the hoarded reserves if central banks do not tighten. Thus, the risk of future inflation depends on central banks’ ability to reverse the liquidity injections and monetary policy loosening at the right time. Financial markets are not expecting such future inflation. But we cannot rule out that central banks err on the side of supporting a recovery at the risk of higher inflation. If China’s policymakers are concerned about this, currency appreciation could shield China from imported inflation.
Many in China are also concerned that US inflation will drive down the US dollar and thus the RMB value of China’s US dollar assets. It will be difficult to insure the existing stock of US dollar assets against such risks. Looking ahead, this risk may be an additional motivation to change the pattern of growth, to reduce foreign reserve accumulation. China can also reduce risks by buying the inflation-adjusted bonds issued in the US and Europe.
Raw commodity price increases could lead to high CPI inflation. However, raw commodity prices typically only soar when global growth and growth prospects are strong. Indeed, as global growth prospects came down sharply last year, primary commodity prices fell strongly, although they picked up again recently as growth prospects brightened somewhat. Moreover, the transmission into CPI inflation has to go via higher prices of manufactured goods.
In China itself, inflation is not a big concern either for now, given the ample spare capacity. Supply shocks or government policy can raise certain prices temporarily, as is happening now with eggs, grain and pork and may happen if the government raises some administered prices. However, given the subdued overall economic conditions, with spare capacity and many people looking for jobs, such developments are highly unlikely to cause sustained, general inflation.
However, unlike in most other countries, in China the monetary expansion is large, and it can have damaging consequences if left unchecked. Abundant liquidity in the banking system can lead to asset price bubbles and increase the risk of misallocation of credit, and thus of resources, as well as of bank loans going bad. The recent global financial crisis has shown the dangers of neglecting asset price increases in monetary and financial policy making. With monetary policy in key high-income countries geared only towards inflation, monetary policy remained loose for too long, even as asset prices rose to levels deemed worrisome by many.
Thus, China’s policymakers are rightly paying attention to the risks of the current policy stance. China’s government has decided that, since there are still downward risks to economic growth and inflation risk is low, the overall macro stance—determined by fiscal and monetary policy—should remain accommodative. But, they are looking for ways to mitigate the risks of asset price bubbles and NPLs, using prudential regulation and other largely administrative measures. As global and domestic growth prospects improve, the overall macro policy stance will have to be tightened as well, particularly monetary policy.