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

China’s Benchmark PBoC rate

china fisher int 2

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.

china fisher inf

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.

china fisher real

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.