Issue 506, February 14, 2011
Translated by Tang Xiangyang
Original article: [Chinese]

In an effort to combat inflation, the central bank is raising interest rates once again.

Two weeks ago, the People's Bank of China announced the first interest rate hike for 2011 in response to a sharp rise in the CPI. Since last October, the central bank has raised interest rates three times.

No one doubts the central bank's determination, but will it be able to keep inflation in check? This year the government will probably try to limit CPI growth to no more than 4 percent.

Last year's CPI grew by an annual rate of 3.3 percent, which was close enough to count as satisfying the goverment's target of 3 percent.

But, based on historical data, we can't be too optimistic that inflation will be kept under control this coming year.

In 2004, officials tried to limit inflation to less than 3 percent, but the actual rate of inflation reached 3.9 percent.

In 2007, they once again tried to keep growth in the CPI to less than 3 percent, however, inflation hit 4.8 percent.

In 2008, the official inflation ceiling was 4.8 percent, but the CPI increased by 5.9 percent.

The numbers may be dull, but they are an indicator of what ordinary people with tightening budgets have been forced to face as the price of essential daily items surge, given the problems associated with weighting in the calculation of the official statistics, prices may actually be rising much faster than the headline figure.

However, inflation is not only a problem that hits ordinary Chinese in their hip pockets, it also effects the stability of the country's macro economy.

Even though not all of the macroeconomic adjustments made by the country are focused on keeping a lid on inflation, still, the inflation target should not be repeatedly missed.

The fact that the official inflation ceiling is repeatedly exceeded is connected to the way in which the figure itself is determined.

Generally speaking, there is a reasonable correlation between the economic growth rate and the inflation rate. Some analysts belive that a GDP growth rate of 8 percent should have a corresponding inflation rate of 3 percent. That begs the question of what kind of economic growth rate we can expect if we set annual inflation targets of between 4 and 4.8 percent?

The problem is that many policy makers underestimate the importance of inflation, especially in comparison to the emphasis they place on economic growth figures.

By setting the GDP target growth rate at about 8 percent, the central government is sending a signal to all levels of local government on the need to pull back on growth a little, to a level that tends to ensure rapid yet stable development for the Chinese economy.

However, local governments always simply have their eye on the GDP growth rate - they don't appear to care if it's good or bad growth.

The result is that over the past few years, the economic growth rates have far exceeded official targets.

The Chinese style of economic growth is driven by investment, it relies on the huge amount of newly issued bank loans.

With too much money being printed and excessive liquidity, it is natural that the government can not meet it's inflation ceiling targets.

Inflation targets are constantly being outstripped by actual rates of inflation, but these statistics mean very little to the average citizen or enterprise, at least, until they are translated into concrete circumstances. For many Chinese, price inflation has brought about a sense of panic, causing many to hoard goods. This furhter contributes to inflationary pressure and fuels a vicious self-strengthening cycle of inflation.

As the reliability of the macroeconomic departments have been challenged, this causes headaches for policy makers who are focused on managing inflation expectations.

In an attempt to maintain its authority, it's very possible that the regulators might unleash sudden and severe price controls. Macroeconomic departments will go all out and use non-market mechanisms to force prices down to a tolerable level.

Since 2003 through to today, anti-inflation campaigns have been conducted in this fashion.

However, many doubts the effectiveness of such measures with many policy makers saying that price controls were useless.

This then begs the question of how best to combat inflation?

One way is directly asking the government to set a more reasonable target that is scientifically calculated, there also needs to be more consideration given to direct and indirect relationships between economic indicators and based on this information, small adjustments can be made thud providing a better gauge of market expectations.

The task of fundamnetally dealing with this embarrassing situation has little to do with the method by which the target is set, but rather, whether policy makers and local government are willing to settle for slower economic growth in order to provide space for a transition to a new model of economic growth and whether the central bank can adopt a more independent stance when considering policy and actions.

This article was edited by Ruoji Tang and Paul Pennay