Inflation may peak soon, but complacency would be risky as economic problems are more structural than cyclical

As the debt crises in Europe and the United States grows and the global economic recovery falters, inflation, together with the dire political consequences it will bring, is making a comeback worldwide. Indeed, emerging market economies are bracing themselves for a serious fight.

China's consumer price index (CPI) jumped 6.4 percent year-on-year in June, reaching its highest level since July 2008. Against the backdrop of a shaky global recovery, concerns have grown about monetary tightening aimed at controlling inflation resulting in a possible hard landing for the Chinese economy.

In China, food prices account for about a third of the CPI basket, with the price of pork a significant component. As a result, the CPI is jokingly known as the "pork price index". In June, pork prices rose 57 percent year-on-year, contributing nearly two percentage points to the overall inflation rate. Unfortunately, macroeconomic policy can do little about the "hog cycle", and usually should not respond to it.

Regardless of the controversy surrounding the adequacy of China's CPI basket in reflecting the reality of underlying price movements, current inflation is more broad-based than it appears. In fact, annual increases in non-food prices accelerated to 3 percent in June, up from 2.9 percent in May. According to China's National Bureau of Statistics (NBS), living expenses increased by 6.1 percent year-on-year in May and many worry that non-food prices may rise higher.

China's inflation problem should not be exaggerated. Barring unexpected shocks, I believe that China's inflation may peak soon, but complacency would be dangerous. From a macroeconomic perspective, China's current inflation is attributable both to demand-pull and cost-push factors.

Historically, inflation in China has followed GDP growth, but with a lag. Today's inflationary pressures are partly the result of the delayed impact of the stimulus package that China adopted in 2009 to fight the effects of the global financial crisis. But China's GDP growth has already started to fall to around 9 percent. In fact, most Chinese economists predicted last year that inflation would peak in early 2011.

Changes in China's financial conditions reinforce this view. Historically, there is a lag of eight to 12 months between M1 monetary growth and inflation. The growth rate of M1 started to fall in late 2009. If past experience is a reliable guide, a decline in inflation is already overdue.

It is the interference of cost-push factors that have contributed to the unexpectedly persistent inflation. The rise in commodity prices since mid-2010 - China's commodity price index has increased by more than 100 percent since its 2009 low - has had an important effect. Moreover, Chinese wages have been rising rapidly.

China's current macroeconomic situation shares many similarities with the situation that it faced in 2007 and most of 2008, when, owing to strong investment and export demand, GDP growth surged significantly beyond its potential. Worried about worsening inflation and a real-estate bubble, China's central bank gradually tightened its monetary stance.

Yet inflation continued to worsen, peaking at 8.7 percent in February 2008. The most difficult period for Chinese decision-makers was between February and September 2008, when, despite abundant signs of a softening in domestic demand, overall demand remained strong, as did inflation.

To tighten or not to tighten: that was the question. The central bank continued to tighten. But the collapse of Lehman Brothers in September 2008 brought global economic growth to a screeching halt. China's GDP growth fell dramatically, owing to the collapse of external demand. To offset this, the Chinese government enacted a 4-trillion-yuan ($621 billion) stimulus package, and the central bank shifted its policy stance abruptly. There is no question about the necessity for the turnaround. However, with hindsight, one might ask whether an earlier loosening would have been wiser.

With taming inflation its top priority, the central bank has raised the mandatory reserve ratio for banks six times this year, commercial banks must now deposit 21.5 percent of deposits as reserves with the central bank, and recently, the one-year lending rate was raised to 6.56 percent and the one-year deposit rate to 3.5 percent.

China's current inflation is not as bad as it was in 2007-2008. The rise in house prices has begun to stabilize, and the impact of the rise in commodity prices is tapering off. But external demand in the second half of 2011 is unlikely to be strong, owing to the shaky global recovery, and the steady increase in production costs, partly attributable to high borrowing costs, is squeezing profit margins - particularly for small and medium-sized enterprises - and declining profits and rising bankruptcies are posing challenges to China's monetary authority.

In view of the need for structural adjustment, the central bank should maintain a tight monetary stance, but it is likely to be a bit more accommodating in the second half of 2011, with a coming decline in headline inflation and amid mounting concerns about growth.

In short, although China will miss its inflation target of 4 percent for this year, price growth will remain under control. In the second half of 2011, China's growth rate could fall further, but there will be no hard landing.

China's economic problems are more structural than cyclical. Owing to a lack of progress in restructuring and rebalancing the domestic economy, the next five years will be difficult, and the window of opportunity for adjustment will close rapidly. But, viewing China's performance in the context of the past 30 years, there is no reason to believe that the country cannot adjust once again.

The author, currently president of the China Society of World Economics, is a former member of the monetary policy committee of the Peoples' Bank of China.

Project Syndicate

(China Daily 08/01/2011 page8)