It all boils down to monetary policy

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By Louis Kuijs (China Daily)
Updated: 2009-09-24 08:25

It all boils down to monetary policy

Amid unprecedented fiscal and monetary stimulus packages announced by many countries to combat the global economic crisis and rapid credit growth in China, many people are concerned over inflation. I would not worry about inflation for now. There is simply too much spare capacity across the world. But very loose monetary conditions in China can cause other damage, and it makes sense to try to avoid future asset price bubbles and problems for banks' balance sheets.

Ample spare capacity across the world makes inflation unlikely to hit any time soon. Milton Friedman says: "Inflation is always and everywhere a monetary phenomenon." But in reality the link between money and inflation is very complex and not so obvious. That is why central banks in most high-income countries now base their monetary policy decisions largely on the balance between demand and supply for goods and services instead of monetary aggregates.

At the moment, spare capacity is high in many parts of the global economy. The Organisation for Economic and Co-operation and Development estimates that in the high-income countries the economy-wide "output gap" will average 5 percent this year. It is sizeable in China, too. This is why international prices of manufactured goods are expected to fall 5 percent (year on year) in US dollar terms this year. Given the subdued global growth prospects, it will take quite a while to remove the slack.

Moreover, the monetary expansions in the US and other high-income countries are at the moment much smaller than many people think. Banks there have used the liquidity injections to restore their reserves, and unprecedented measures have been taken to avoid a credit crunch.

Once economic growth and bank lending gain steam again banks could lend out multiples of the hoarded reserves if central banks do not tighten the rules. Thus, the risk of inflation depends on central banks' ability to reverse the liquidity injections and the loosening of monetary policy at the right time.

Financial markets are not expecting such inflation. But we cannot rule out that central banks err on the side of supporting a recovery at the risk of higher inflation. If China's policymakers are concerned about this, the upward revaluation of the yuan could shield the country from imported inflation.

Many in China are concerned that inflation in the US will drive down the greenback and thus the yuan value of China's assets in dollars. It will be difficult to insure the existing stock of US-dollar assets against such risks. Looking ahead, this risk may be an additional motivation to change the pattern of growth to reduce foreign reserve accumulation. China can also reduce risks by buying inflation-adjusted bonds issued in the US and Europe.

Increases in the prices of raw commodities could lead to a high consumer price index (CPI). But raw commodity prices typically soar only when global growth and growth prospects are strong. As global growth prospects came down sharply last year, primary commodity prices fell strongly, although they picked up recently as growth prospects brightened somewhat. The transmission into a high CPI, however, has to be through higher prices of manufactured goods.

In China, too, inflation is not a big concern for now because of the ample spare capacity. Supply shocks or government policies can raise certain prices temporarily, as is happening now with eggs, grain and pork, and may happen if the government raises some administered prices. But given the subdued overall economic conditions, with spare capacity and the hunt for jobs by many people, such developments are highly unlikely to cause sustained, general inflation.

Unlike in most other countries, however, the monetary expansion is large in China and it can have damaging consequences if left unchecked. Abundant liquidity in the banking system can lead to asset price bubbles and increase the risk of misallocation of credit, and thus of resources, as well as of bank loans going bad.

The global financial crisis has shown the dangers of neglecting asset price increases in monetary and financial policymaking. Monetary policy remained loose for too long in key high-income countries (since they were geared toward inflation) even as asset prices rose to levels deemed worrisome by many.

Thus, China's policymakers are rightly paying attention to the risks of the current policy stance. The Chinese government has decided that, since there are still downward risks to economic growth and inflation risk is low, the overall macro stance - determined by fiscal and monetary policy - should remain accommodative.

But they are looking for ways to mitigate the risks of asset price bubbles and non-performing loans, using prudential regulation and other largely administrative measures. As global and domestic growth prospects improve, the overall macro-policy stance will have to be tightened as well, particularly the monetary policy.

The author is a senior economist at World Bank Office in Beijing

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