I suspect that if the panic button hasn’t been pressed before then, a 10% CPI number in May should be enough to set it off, although I still think there is enough confusion in policy-making circles about the causes of inflation that it may be a while before a consensus develops over what needs to be done. My guess is that if we do see May numbers exceed 10% there will be at best an acceleration of current policies to restrain inflation, but I don’t think these will have much effect.
In their report yesterday ICBC also said that inflation would begin to decelerate in the second half of 2008 as the government’s macro controls and support for agricultural production began to take effect. I of course am skeptical. I do not believe the government will be willing to tighten by nearly enough to wring out several years of excessive monetary growth. I suspect we will need to see continuing accelerating inflation well into the end of 2008 before there is enough of a consensus built to recognize that inflation is not a temporary problem and must be addressed more vigorously, even at the cost of a short-term rise in unemployment.
Nonetheless as long as there is a sense that the fundamental problem is a food-supply constraint, the government continues to try to encourage an expansion in agricultural expansion. Amid spreading talk around Asia of a rice crisis, Jiang Dingzhi, vice chairman of the China Banking Regulatory Commission, urged banks yesterday to ensure loans and credit to grain producers and other agriculture-related enterprises, even while they maintained strict loan caps. In an effort that I think is unlikely to bear much fruit, Jiang even urged rural cooperatives, commercial and policy banks to "follow credit ethics and take on their social responsibilities to support rural development," according to a Xinhua report today. I am not sure appealing to their "better" instincts is an effective way to get the responsible parties to do what the government wants, but even if these kinds of appeals are successful in raising agricultural production, it will just make it easier for inflationary pressures to show up in the non-food component.
Why do I say this? This month the Far East Economic Review published my piece explaining why I believe that "solving" the food problem will not solve the inflation problem. In the article I point out that from the monthly releases provided by the NBSC since last year, it has been clear that almost all of the increase since last year in the value of the CPI can be explained by the roughly 20% increase in food prices. The price levels of the non-food component of the CPI have been relatively stable, rising at well under 2% year on year. This seems like prima facie evidence that inflation in China is primarily, if not exclusively, a food problem, caused by food supply constraints that are temporary in nature.
So according to the pork model of Chinese inflation (based on MIT professor Ken Rogoff’s formulation of the debate as pork versus money), China is not suffering from monetary inflation. It is suffering rather from a sharp and unexpected decline in agricultural production relative to the rising food-consumption needs of a large, rapidly growing economy. Once the factors that have constrained food production are eliminated or wear off, the growth in food production will keep up with Chinese consumption needs and the price of food will return to levels consistent with the PBOC’s inflation target of 3% or lower.
For believers in the pork model the real danger facing China is that several months of high food-based inflation can nonetheless cause a generalized change in inflation expectations, which itself will change the behavior of households, consumers and producers in ways that will lock inflation into place. On February 11 Premier Wen very specifically addressed concerns about inflation expectations when he said: "We are sticking to the 4.8% target because it helps stabilize consumer expectations. When prices soar, expectations can be more horrifying than the increases."
The concern expressed by Premier Wen and others in his government is that if workers begin demanding higher wages to compensate them for the decline in their purchasing power, if households worried by rising prices accelerate their purchases of consumer goods, and if savers reacting to the negative real interest rate on bank deposits withdraw money from the banking system and spend it, their behavior can cause inflation to spread into other sectors of the economy. In this case the main strategy of the government must be to create the necessary incentives to get agricultural production back on track as quickly as possible and to squeeze out inflationary expectations—partly by constraining demand, partly by selling food reserves, partly by freezing prices and partly by simply talking down inflation prospects, as Premier Wen was seen to be doing.
Given that CPI inflation has largely been limited to food, how can monetarists argue that inflation in China is caused by too much money, and not too little pork? Aside from the fact that the prices of a number of non-food components such as gasoline prices are frozen, so that their inflationary impact shows up not as CPI inflation but as lower profits or higher taxes (but the upward pressure nonetheless exists), there is a much more serious argument as to why non-food inflation is actually too high and possibly indicative of more generalized inflationary pressure.
In order to see why, it is important to remember that a price increase in any particular good or group of goods caused by a supply constraint is not inflationary. Prices of individual goods and services rise and fall all the time, whether the overall monetary environment is stable, inflationary or deflationary. Normally the only effect of a price rise in a particular good should be to cause a shift in relative prices, not average prices. If the price of food rises, in other words, it should cause a diversion of spending away from non-food goods and services, so putting downward pressure on the prices of those other non-food goods and services. In a perfect world, the downward pressure on other prices would net out perfectly against the rising price of food. Although there would be a change in relative prices there would be no inflation, which is a change in average prices
Of course we don’t live in a perfect world, and because of various kinds of price stickiness price changes do not necessarily net out. Still, the price-equalizing pressures are there, and it is even possible to calculate how much the price of non-food goods and services would need to decline to maintain the balance. This allows us to measure the downward pricing pressure that rising food prices are placing on the rest of the economy.
If we assume that the PBOC is running a monetary policy that is consistent with a target of 2% to 3% inflation, the 18.5% rise in food prices year on year to January 2008 would require a sharp decline in other prices in order for the PBOC to attain its inflation target. Specifically, the price of non-food goods and services would have had to decline by 5% to 6% year on year in order for overall inflation to fall within the PBOC target. (I am not using February CPI numbers because they were exceptionally high and may distort the calculation, but if we used them, non-food prices would have had to decline by 7% to 8% for the PBOC to attain its inflation target.) Food inflation, in other words, should cause such a large diversion of spending away from non-food goods and services that their prices would have to fall by nearly 5% or more if the PBOC’s monetary policy and inflation targets were credible.
It might be unreasonable to expect 5% deflation in the non-food component of the CPI basket, but certainly China does have a recent history of price deflation in many goods, and there is no reason to assume that prices in China are so sticky that deflationary adjustments are impossible. Clothing prices in China, for example, have fallen pretty consistently year on year by an estimated 1.7%, 1.9% and 1.4% during the three months to February, according to an April 3 report just sent to me by Macquarie Bank’s Paul Cavey. Still, even if deflation of this magnitude were unrealistic, sharply rising food prices should nonetheless have put significant downward price pressure on the non-food sector, and this downward pricing pressure should have had at least some material impact on actual price performance.
Under these circumstances the fact that non-food inflation is low but rising, and has in fact accelerated to 1.6% in February from 1.5% in January (rising nearly 3% in February on an annualized basis), is not very comforting. Instead of significant downward pressure on Chinese CPI inflation there is small, but upward pressure. This suggests that monetary policy has been too loose and that there is an underlying monetary cause to inflation. The food-supply constraint has helped mask the monetary pressure for inflation by diverting increased spending towards food and away from non-food goods and services.
But it has only masked this pressure—it did not create it. Thanks to abnormally fast-rising food prices, in other words, inflation has not yet shown up in the non-food component because rising food prices have absorbed the inflationary consequences of an excessively loose monetary policy. Once food prices stop rising dramatically, however, inflationary pressures will show up in a much broader range of goods and services.