What Determine China’s Inflation

What Determine China’s Inflation?
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Huang Yiping
China Center for Economic Research, Peking University (yhuang@ccer.pku.edu.cn)
Wang *un
China Center for Economic Research, Peking University Hua *iuping
Research Department, China Finance 40 Forum

[Abstract] We e*amine determinants of inflation in China. Analyses of
both year‐on‐year and month‐on‐month growth data confirm e*cess
liquidity, output gap, housing prices and stock prices positively affecting
inflation. Impulse response analyses indicate that most effects occur during
the initial five months and disappear after 10 months. Effects of real
interest rates and e*change rates on inflation are relatively weak. Our
results suggest that output gap is as important as e*cess liquidity in
e*plaining inflation trajectory. The central bank should closely monitor
asset prices given their spill
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ionary package, new
credit e*tension surged, amounting to CNY7.4 trillion during the first half of 2009 or
equivalent to 150 percent of PBOC target for the whole year. This quickly gave rise to
renewed concerns about potential inflation.
Intensifying the inflation worry, CPI returned to positive territory before the end of 2009
and recorded a surprising 1.9 percent in December. But economists’ assessment of
inflation outlook remains divided. Some argue that e*traordinary loan growth in the
preceding year implies much higher inflation. Others suggest that inflation pressures are
likely to remain modest in the near future given e*isting overcapacity problems, pointing
to 0.2 percent non‐food CPI in December.
Should the central bank quickly rollback the e*pansionary monetary policies in order to
maintain macroeconomic stability? This is a key question lies at the center of the policy
debate in early 2010. Monetarists believe quantity of money is the single most important
factor determining price levels in an economy. Structurists may argue that when
productivity growth is strong and overcapacity problem widespread, monetary e*pansion
may not always lead to high inflation immediately. Yet others worry about the spillovers
from asset prices, such as housing and stock prices, to CPI.
In this study, we intend to address the key academic question relevant to the current
policy debate: what determine inflation rates in China? We e*amine impacts of e*cess
liquidity, output gap, housing prices, stock prices, real interest rate and real effective
e*change rate on CPI inflation. The first two independent variables are conventional suspects of causes of inflation. And inclusion of interest and e*change rates should offer
insights on these instruments’ effectiveness in dealing with inflation problems in China.
In light of the debate about Greenspan’s monetary policy, asset prices, CPI inflation and
the subsequent financial crisis in the U.S., we also include housing prices and stock prices
as potential determinants of inflation (Henderson and Hummel 2008, Greenspan 2009).
Whether or not PBOC should take into account conditions of the asset markets has also
become a subject of policy discussion in China. In order to better understand the behavior
of asset prices, we take a step further to e*amine determinants of both housing and stock
prices.
For the purpose of this study, we assemble a monthly time series data set for the period
January 1998‐July 2009. Most statistical data reported by the National Bureau of Statistics
(NBS) are in year‐on‐year change terms. However, month‐on‐month data probably
provide more accurate information about short‐run momentum. We conduct detailed
analyses for both sets of data.
Findings of this study are consistent with general e*pectations. E*cess liquidity leads to
inflation pressure and output gap also has positive impact on inflation. Asset prices have
spillovers to CPI inflation, although the monthly impact trajectories are more complicated.
Finally, there is no strong evidence that real interest rates and real effective e*change rates
Granger cause lower inflation, although they do impact positively on asset prices. Most of
the discovered effects occur within the first five months and disappear almost completely
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