Monetary Policy and Chinese Inflation

The discussion about inflation in China is getting a bit out of hand. Here’s Andy Xie’s most recent article where he describes 4.4% inflation in China as a prelude to hyper-inflation across the world:

I have argued before that the Fed’s QE will first stoke inflation in emerging economies and, via commodities and trade, back to the US.  Because the lag between the Fed’s QE and the US’s inflation is quite long, when the Fed sees inflation, it will be too late to stop.  The inflation in the pipeline will take years to work through.  The second decade of the 21st Century will look remarkably similar to the 1970s.

Non-food inflation in China is currently 1.2%. How low exactly does inflation have to be before its not a problem?

I know, I know, we’re talking more about inflation drivers, and as Aaron Back points out in the Wall Street Journal, inflation seems to be following money supply at a delay of 12 months.

So lets look at the real monetary policy behind this. As David Kotok points out, there’s a lot of disagreement about how one should treat food price inflation. But the main take away is that monetary policy only really effects food prices through controlling inflation expectations:

Suppose you are the governor of the central bank. You have to set your policy interest rate. Do you base that decision on overall inflation rate of 10% or on the core inflation rate of 5%? Or are you going to confront the food inflation rate of 15%. Let’s further assume that your economy is growing at a trend rate of 5% and all other aspects are in trend or neutral position. You have no negative output gap and no above trend pressures. Your only direct problem is what to do about inflation.

My economist friends who answered offered a suggested policy rate as low as 6% and as high as 13.5%. The answers were about equally divided and the respondents sample size is over 20. The distribution of answers was distinctly bi-modal. About half the answers were bunched in the lower range of 6%-8%; the other half were in the double digit area between 11% and 13.5%.

Some worried that setting the policy interest rate in double digits would impose a very high financing cost on the non-food portion of the economy and cause it to go into recession. They argued that the real (inflation-adjusted) rate of interest for that non-food half of the economy would be 7% or so. That would set the threshold of finance too high.

Others argued that the monetary policy expectation effect would cause the rate of inflation to accelerate if the policy rate was not set in double digits. They were willing to take the recession in the non-food area in order to keep inflation expectations under control. No one mentioned substitution effects. Perhaps that was overlooked. Or it may be because rice and wheat are not easy cultural substitutes and those grains are each experiencing their own price pressures.

The basic moral is that the question is whether companies will demand higher costs for their goods because they expect a rise in the cost of living, or whether the higher cost of lending will force the companies to operate less. There is a fair amount of agreement though that QE won’t effect the demand for food, whereas today weather is quite clearly effecting the supply of food. Most likely China will take action to avoid drawing spurring inflation expectations (as they have already done somewhat), but because of a large labor surplus there is little need to worry that wages will get too far out of hand.

If core inflation continues along trend this could be a concern. But export growth, and growth in general is already slowing in China, and looks likely to continue doing so into the middle of next year. China has been fairly quick on the monetary button, and assuming they continue to act this way core-inflation could flatline early next year, and even start lowering as the year continues.

There are a few reasons to think that China could be in for more inflation in the future. South Korea and Japan were at much higher inflation levels during this stage of their development, and there are signs that China’s labor market is getting somewhat less flexible. But things are changing only by degrees. We are still a long way from the 1970s.