Can we see the Fisher Effect in China?
As I look at different countries for evidence of the Fisher Effect, the thought occurred to look at China. Would the Fisher Effect be discernible since their central bank’s (PBoC) nominal rate is not at the ZLB? It is free to move anyway it chooses. But then one realizes that they hold their PBoC rate stable for years on end, which opens the door to observing the Fisher Effect directly.
Let’s first realize that there is concern in China that inflation is too low. Core inflation is currently reading at 1.6%, which is below their target of 3.5%. There is more to that story, but can the Fisher Effect help us understand what is going on there?
This post will gather the variables for the Fisher Effect equation…
Natural inflation rate = Projected PBoC benchmark rate – Natural real output growth
(charts from tradingeconomics.com)
China’s Benchmark PBoC rate
Their central bank rate has been between 6.0% and 6.6% since 1st quarter 2011…. 3 years already.
When the PBoC rate stops actively moving, the Fisher Effect steps in and inflation starts drifting toward its natural level. So do we see inflation heading toward a natural level, or what Paul Krugman might call its “Stall Speed”? (source, page 13)
China’s Core Inflation
Well, let’s look at the behavior of inflation over these years of a stable PBoC rate.
After the crisis, inflation was rising and the PBoC raised their benchmark rate to slow it down. Eventually inflation backed down to 1.5% or so, and by July of 2012, the PBoC rate declined to the 6.0% that we still see today. Inflation has been fairly stable for 3 years since, yet still below target.
So does this stable inflation reflect the natural rate of inflation from the Fisher Effect? Well, once the PBoC rate is held constant, inflation will start to drift. If inflation drifts up, the natural inflation rate is above. If it drifts down, the natural inflation rate is below. If it doesn’t drift at all, the natural rate is matched to the PBoC rate.
China’s Real Output Growth Rate
One more variable of the Fisher equation… the real rate of output growth. Here is chart for China’s annual GDP growth rate at constant prices.
Real output growth has been slowing down. The 9.5% actual rate of real output growth is questionable. Many put it closer to 7.4%, which is more reasonable.
So can we see evidence of the Fisher Effect in China?
With a constant PBoC rate, it makes sense that inflation was rising a bit as the real growth rate slowed down. The stability of these relative movements seem to support the passive dynamics of the Fisher Effect. But there is more happening here. Let’s explore…
Why doesn’t China lower its nominal PBoC rate in order to push inflation up to its 3.5% target?
Let’s remember that financial repression is alive and well in China, and that means that monetary policy already calls for lower nominal rates to benefit investment at the expense of households. It also means that overly aggressive investment can push inflation artificially higher just like lower nominal rates could do. If investment was relaxed, inflation would fall.
Time to estimate the Fisher Effect equation for China
Natural inflation rate = Projected PBoC benchmark rate – Natural real output growth
-1.4% = 6.0% – 7.4%
What?! Could this be a mistake? The natural inflation rate is negative?!
The natural inflation rate can go negative if financial repression is severe enough. China’s level of financial repression is very severe. They aggressively lower nominal rates to boost output growth at the expense of household consumption. Fighting a lower inflation is their constant challenge. But it is clearly not a sustainable monetary policy.
There is a tendency toward lower inflation in China according to the Fisher Effect. This is why inflation can consistently run below target.
If there is a tendency to deflation, why don’t we see the PBoC rate going steadily down to keep inflation from falling to its lower natural level? Well, investment has been exploding unsustainably at 50% of GDP counteracting the tendency to lower inflation.
Also, realize that inflation was running at 1% in China before the crisis, after a decade of falling labor share. Then they easily went into deflation during the crisis. Then they took extraordinarily bold actions of aggressive investment policy that propped inflation back up. But many investments will become non-performing loans and watch out.
So what might a more sustainable Fisher Effect equation look like for China?
2.0% = 7.0% – 5.0%
Yes… a higher nominal PBoC rate with more moderate growth. Doesn’t that look better? It’s better for households in China too.
It would be prudent for China to stop financial repression, raise the PBoC nominal rate, allow labor share to rise and thus raise their natural inflation level. Yet China has released its inner capitalist-child and its immaturity is evident.
UPDATE: An expert on China, Michael Pettis, wrote about the bifurcation in monetary policy. This is where money supply grows among producers but not among labor/households. (December 2013)
“As long as the rest of the world can accommodate the consequent excess of production over consumption, the bifurcation in monetary policy will not seem to be a problem, but once the world cannot accommodate it, the bifurcation of monetary expansion will create deflationary pressures.“
“Deflation or disinflation partially or wholly resolves the bifurcation by forcing real interest rates towards their “correct” level (because real deposit and lending rates rise in a deflationary environment in there is no change in the nominal interest rate). Under deflation we would expect to see the gap between consumption growth and GDP growth narrow, or even reverse.“
As he says, deflation would be a natural or “correct” part of China’s re-balancing…. and re-balance they must.
Any thoughts on this factor in the lack of inflation?
“In most economies, that would lead to rampant inflation, but if we look at the rise in China’s Consumer Price Index over the last two years, it’s usually been in the range of 2 to 3 percent, and only occasionally above 3 percent. During the last decade, there have been only two occasions when prices rose sharply: in 2008, when the increase topped 8 percent, and in 2011, when it peaked at about 6 percent. Why has large-scale monetary inflation failed to trigger price inflation?
From official quarters, we hear denials that China’s money supply is inflationary. Sheng Songcheng, the head of the central bank’s statistics and analysis department, said in January that the money supply was large because the savings rate and the ratio of indirect financial investment (that is, funding in the form of bank loans) were high. China has one of the highest household savings rates in the world, surging recently to 50 percent of disposable income (although it is only a minority of households driving the trend).
Economists differ as to what this all means, but one professor of literature has coined a term for it: “the economics of corrupt officialdom.” Corrupt officials, he argues, have a lot to do with the absence of price inflation.
Corrupt officials generally do not spend the huge sums they acquire from kickbacks, and are loath to deposit their money in banks for fear it will be discovered. So they hide their money instead. The professor estimates that as much as 50 percent of the surplus money supply may have been taken out of circulation for this reason.
China’s Internet commentators have seized on this phenomenon, hailing dishonest officials’ creative ways of hiding money as performance art.
For example, Xie Mingzhong, a former Communist Party secretary of Wenchang in Hainan Province, was dismissed after he allegedly concealed more than 25 million yuan in safe deposit boxes.
Yan Dabin, the former chief of the state communications bureau in Wushan County, Chongqing, hid cardboard boxes containing 9.39 million yuan in the bathroom of his new apartment, where they were discovered after a water leak.
Xu Qiyao, a former chief of the construction department of Jiangsu Province, accepted some 20 million yuan in bribes. Parts of that sum were wrapped in layers of plastic and hidden in a hollow tree trunk, beneath an ash heap, in a rice field and inside a latrine.
Li Guowei, the former chief of the highway bureau in Ganzhou, Jiangxi Province, buried a box stuffed with 2.8 million yuan in a garbage heap next to a brother’s house. “I was an unlucky dog when I got picked out,” he said.
Luo Yaoxing, the former chief of the immunization planning office of the disease control center of Guangdong Province, rented a luxury apartment to store his booty. He wrapped the notes tightly inside black plastic bags. Despite protecting his stash with waterproof paper and drying agents, 1.2 million yuan still got moldy.
The list goes on. Despite a wave of prosecutions over the past decade, there is little reason to believe that much has changed. In December, a former deputy director of the Hohhot Railway Bureau in Inner Mongolia, Ma Junfei, was given a suspended death sentence for accepting bribes and concealing the sources of his immense fortune. His annual salary would have been only about 120,000 yuan ($19,300), but his two houses were stuffed with cash and gold with a value of more than 130 million yuan ($21.48 million). During his trial, Ma Junfei admitted that concealing the money he had received in bribes was a colossal headache.
The professor’s estimate that half of the money supply surplus has been salted away by corrupt officials is a calculation based more on poetic license than empirical evidence, but I have no doubt that the total of stolen cash is big enough to play a role in curbing price inflation at a time of monetary expansion. Like most Chinese, I am sure that those officials who have been brought to justice represent the tip of an iceberg of kickbacks and bribes.
Of course, “the economics of corrupt officialdom” can’t stop prices from rising. That is one change ordinary Chinese have become very conscious of in recent years: Everything is getting more expensive — only the money gets cheaper.”
There is lots of corruption in China. I remember and old Hong Kong businessman in Hawaii telling me that China is a country of pirates. Apart from the corruption, they really like to keep their labor costs down.
So inflation in China is caught between to extremes. Low labor income pulling inflation downward. Exponential investment pushing inflation up.
Once the investment wears out, low labor income will win the battle. It is only a matter of time. Recession will appear.
Some may like to think that China will never go into recession. The US thought that too. A recession in China is only a matter of time. And it will be good for the US. Also, China will not be able to invest its way out of the next recession like it did in the crisis.