China: Inflation & Monetary Policy

Keynesian economists over at the IMF want to stimulate the Chinese to stimulate their economy. The IMF’s China economic outlook report released on Monday urged the Chinese to increase their government budget deficit to 2% of GDP rather than aiming to lower this percentage. What’s the panic about? Well, you see, if Europe’s economy falls into a recession, the Chinese should step on the fiscal accelerator just as they did in late 2008. The IMF recommends cuts in consumption taxes and new subsidies for consumer-goods purchases and for corporate investments in pollution-control equipment.

Do you think that the Chinese need or welcome such advice? The Keynesians have spread fiscal recklessness throughout the world, and want to make sure that China participates. In any event, the Chinese are better at monetary than fiscal policy recklessness. No central bank on earth has pursued quantitative easing for as long or on a bigger scale as has the People’s Bank of China (PBoC). The PBoC’s assets have increased by 170% over the past five years to a record $4.44 trillion in December. That compares to $2.87 trillion at the Fed and €2.74 trillion at the ECB. The PBoC accomplished this feat by accumulating foreign exchange reserves, which accounted for a record 83% of the central bank’s assets at the end of last year, up from 40% at the start of 2002.

All this liquidity has the potential to boost inflation in China. It did just that over the past three years as the y/y CPI inflation rate rose from a cyclical low of -1.8% during July 2009 to a recent cyclical peak of 6.5% during July 2011. The PBoC responded by, in effect, “sterilizing” some of the increase in its foreign exchange reserves by increasing bank reserve requirements since November 2010. But faced with a slowing economy, the PBoC lowered its reserve requirement ratio by 0.5 percentage point in December, the first such cut since December 2008.

Additional easing was expected this year after December’s CPI report, released last month, showed that the inflation rate was down to 4.1%. However, this morning, we learn that it rose to 4.5% during January. The problem may be a temporary seasonal blip in food prices. Excluding food, the CPI was up only 1.8%. Also encouraging is that China’s PPI inflation rate fell to 0.7% during January, the lowest since November 2009. This rate tends to be a leading indicator for the China’s CPI. (More for subscribers.)