None of the latest data released from China were good. Inflation was higher than expected while all other quantity growth rates were lower than expected or declining, arousing the worry of stagflation. Stagflation is by definition a higher price (growth) with a lower quantity (growth), and is highly likely a result of a leftward shift of the supply curve. Since the bad numbers happened under COVID lockdown, most analytics would attribute the former to supply bottlenecks, as the Federal Reserve labeled the uncontrolled inflation problem. But in fact, it is not the case.
While in the United States, demand is still very strong regardless, be it in goods, housing, or the labour market. The problem is only inflation without stagnation. In China however, inflation remains very low by any emerging market standard (a more usual inflation target is 4 percent), despite that in the rest of the world it has been edging up for more than a year. The failure of inflation pickup during observable weak quantity growth suggests China is undergoing a negative demand shock. Even though negative supply shock cannot be ruled out, and the former is more than enough to offset the latter.
The problem being more on the demand side can also be seen from the monetary variables, as are shown in the accompanying chart. The first evidence is from the ratio of the growth of broad money (M2) to narrow money (M0). In recent months, M0 growth surged strongly but M2 growth remained subdued. This means the multiplying effect of recycling deposits to loans is weak so that augmentation of narrow money to broad money is slow. Unfortunately, it is the broad money that matters.
The second evidence of weak demand is the failure of the transmission mechanism from broad money to credit. Money is being held as stock. A stock of money, no matter how large the pile, if it is left idle in the bank (storage) it will not generate any value-added or inflation. By definition, it has to flow as credit (loans) in order to be meaningful. Even though recent M2 growth has been increasing mildly, loans growth has been on a persistent downtrend since 2015. Coincidently, housing and debt problems emerged about the same time. The deleveraging of such massive sectors is the cause.
A weak demand can in principle be boosted by countercyclical monetary or fiscal policies. However, a deleveraging of housing and debt markets is more secular and structural than cyclical, where countercyclical policies cannot help. Japan is one of the classic textbook examples of this: to tackle the problem face-on, a neo-classical answer would be hands-off and let the market settle on its own. This means massive business closure and unemployment in a relatively short period of time. Most governments do not have the political will to achieve this, so they step into Japan’s footprint and try the countercyclical approach.
Even if this long but less painful approach achieves a so-called soft-landing, the prolonged dim outlook retards expectations which govern longer-term economic decisions. Accordingly, this ruins most positive effects of any countercyclical polices. And persistent policy failures, in turn, generate negative feedback.
