Economists and the general public generally think of inflation as bad.
Inflation erodes purchasing power, making goods and services more expensive in real terms and making people less certain about future decisions, such as investments and where to work. China, however, suffers from the opposite problem of flat prices following recent price declines. So if China needs inflation, why can’t it get any?
It is actually wrong to think economists do not want any inflation. In reality, the general economic consensus holds that central banks should target a low inflation rate of, say, about 2 percent and steady rates of inflation. An inflation rate of 2–2.5 percent is thought to be the general Goldilocks rate in normal times, where it is not too high to discourage growth but just high enough that during downturns, the rate can be lowered to boost growth.
Though most of the general public pays less attention to inflation expectations, economists tend to pay more attention to how central banks spend much of their energy. Inflation expectations matter enormously because they drive so many decisions that consumers and firms make and create a self-perpetuating circle. If consumers expect prices to go up in the future, they may buy something now, causing the price to go up and confirming their expectations. Central banks target steady expectations of low growth in prices.
All countries, especially highly indebted countries such as China and increasingly the U.S. federal government, need low inflation and interest rates. Take a simple example: If a government pays 1 percent interest on a long-term bond but the inflation rate averages 2 percent, the government is actually paying a negative real interest rate of 1 percent.
To manage growth, inflation, and interest rate expectations, central banks assume that the problem is excess demand from the start. Maybe interest rates are too low, firms and consumers are borrowing too much, or the government is running too large a deficit, which is pushing up economic activity above its long-term rate, driving inflation. However, what if this is wrong and the driver of inflation comes not from excess demand but from supply?
China has a very low consumption rate, with most of its economic activity being driven by investment in everything from real estate to infrastructure and industrial development. When an additional industry, from real estate to goods manufacturing, suffers from oversupply, the price of goods declines. So if the inflation dynamics in a country stem from massive oversupply pushing down prices coupled with a government focused on increasing industrial investment, what will lower interest rates accomplish?
If the problem with deflation is too little demand, then lowering interest rates will help increase demand by stimulating investment. However, if the problem is too much supply, lowering interest rates will simply increase investment and supply, perpetuating price declines. In other words, contrary to the conventional wisdom, lowering interest rates will not increase inflation but lower prices.
In reality, this is the conundrum China faces. Lending to manufacturing and industrial sectors has grown strongly in the past year, even as real estate lending has gone flat. Producer prices were negative before the COVID-19 outbreak and experienced a bump post-pandemic, when they were growing again but have since turned negative, down 5 percent in July 2023 and down most recently 3 percent.
With most headline sectors depending heavily on government subsidies and incentives to stay afloat, the new financing is either propping up firms that should exit the market or building new capacity in an already flooded market. Lowering interest rates, typically viewed as the best channel to boost inflation, is likely here to exacerbate inflation as new capacity comes online and firms fight to stay alive.
The reality is that this is a political decision with no simple fix. Whereas central banks in the United States and Europe guard their independence, the People’s Bank of China is a political animal subservient, like all things in China, to the Communist Party. Beijing has declared its intent to dominate production, specifically in key and high-tech sectors. In other words, though this may bring about deflation, the Communist Party has no intent of changing its monetary policy to propel higher-quality growth.
If economics mattered, then policy analysis and what to do with interest rates would become more straightforward, albeit something outside the normal framework. However, under the Communist Party’s guidance, economic rationale should not be expected to carry the discussion.
