Too Early to Declare Victory on Inflation

On Friday, I was interviewed on NPR about rising prices in China.  You can read and listen to the report here. 

As the story notes, word on the street — prior to the official announcement — is that China’s consumer inflation rate (CPI) will come in at 4.3% for December 2010, down from its 5.1% spike in November.  I’m not at all surprised.  While I’ve consistently argued that pent-up inflation poses a serious threat to China in 2011, I’ve also been predicting that we would almost certainly see the CPI rate dip in December, given the government’s high-profile crackdown on food prices.  My reasoning was based on politics, not economics:  it was politically imperative for China’s leaders to show they were taking action to rein in the skyrocketing cost of living, and they had the tools at their disposal to enforce a short-term, targeted result.

Price controls, and related crackdowns on speculation and hoarding, make bold headlines but do nothing to solve the economic pressures causing inflation.  In China, those pressures arise from the fact that, due to China’s stimulus policies, its money supply has expanded more than 50% over the past two years.  There’s just more money out there chasing the same amount of goods.  Capping prices can’t change the fact that money buys less; it only changes how people are forced to deal with that fact – usually in a way that creates even bigger problems, like shortages or black market corruption. 

But that doesn’t mean price controls have no impact.  Assuming they are enforced, price caps obviously can have a immediate impact on – you guessed it – prices, particularly those that are visible enough to be measured in CPI (if a price is visible enough to be measured, presumably it can regulated).  Prices are prevented from going up, so “inflation” appears to go down.  Whether this short-term impact is a lasting “solution,” however, is another matter entirely.

The temptation — now that the upward trend line has been broken —  will be for the Chinese government, and other observers, to conclude that inflation has peaked, and declare “victory.”  I can already hear them saying how — through a wise combination of price controls, quantitative tightening (through raised bank reserve requirements), and modest interest rate hikes — China has “turned the corner” on inflation, and we can all relax.  I couldn’t disagree more.

What we’re in for, I fear, is a replay of what happened in China’s real estate market last Spring.  In April, the Chinese government – worried about a property bubble – rolled out a whole raft of restrictive “cooling measures” to clamp down on “speculation.”  Prices almost immediately dropped – in part because officials instructed developers to take their more expensive units off the market temporarily.  Transaction volumes also dropped, as buyers and sellers both held back to see what would happen.   

By May, authorities were pointing to declining sales and prices as proof that the property bubble was “solved” – if one had even existed in the first place.  I remember being on a panel with Fan Gang, one of the Chinese government’s top economic advisors, around that time.  The topic was “The Chinese economy – Should we be worried?”  He stood up and said (to closely paraphrase), “A month ago, I was worried.  But I’m not anymore, because the government has stepped in and the figures show the property bubble has been deflated.”

My reply was, with all due respect, “not so fast.”  The government’s “cooling measures” had certainly had an impact on the market, but declaring victory was premature.  In my view, none of the largely top-down, administrative measures did anything to change the dynamics that drove so many people in China to pour their money into real estate, and unproductive real estate in particular.  I suspected that, once buyers and sellers got a lay of the land, and figured out how to game the new restrictions, property prices would come surging back probably in the second half of the year.  That’s exactly what happened.  Now we’re right back where we started, talking about a frenzied market and fears of a bubble.  Premier Wen publicly admitted, over the year-end holidays, that the government’s “cooling measures” had essentially failed. [Here’s a quick clip of me making this analysis and prediction on TV in July).

So where does that leave us, looking at consumer inflation?  Like the sale volumes and prices of condos last Spring, a Chinese Consumer Price Index (CPI) subject to enforced price caps doesn’t tell us very much about the real dynamics at work in the economy, and may paint a misleading picture of what to expect.  What matters isn’t CPI the month after the government claps down price controls, it’s CPI six months or a year later. 

Of course, the Chinese government hasn’t just relied on price controls – it also has raised interest rates (slightly) and raised bank reserve requirements (to mop up excess liquidity).  To get a read on whether these measures have made any dent in the real factors driving inflation in China, I’ll be looking at net new bank lending and the money supply figures for December and the first couple of months this year.  Last year, despite plenty of talk about “tightening,”  Chinese banks lent nearly RMB 8 trillion, almost double the level of any other year before their unprecedented RMB 10 trillion blow-out in 2009.  Perhaps even more to the point, China’s M2 measure of money supply was up 19.5% this November compared to last (Want China Times, quoting China’s Southern Weekly, has an excellent, concise article on this subject here, and really nails the issue on its head).

Unless these two measures – new lending and monetary expansion – show some signs of being brought under control over the next few months, the dynamics driving China’s recent surge in consumer inflation won’t change, and December’s price controls will just be a speed bump on the road to runaway prices.  If you want to know whether China really has “turned the corner” on inflation, those are the tea leaves worth reading.

[For those who are just joining this discussion, I recommend checking  out my Bloomberg op-ed from October in which I anticipated China’s latest surge in inflation and explained the key dynamics I saw at work].