China Urged to Adopt a 2% Inflation Target for Economic Balance

In the 1990s, the UK, New Zealand & Australia adopted a new economic trend of inflation targeting, with the aim to stabilize their economies. Later on, the Federal Reserve & European Central Bank & other major central banks adopted a 2% inflation target goal.

Now in 2024, China is also considering using inflationary targets to tackle sluggish economic growth and deflationary pressures. 

China's Economic Challenges

China was once one of the fastest-growing economies in the world, but now it's facing quite the opposite problem of deflation. Consumer prices have been rising at a very slow pace and factory gate prices have been declining since 2022. Because of this, the idea of adopting a 2-3% inflation target has gained some support among economists. 

Huang Yiping, a prominent adviser to the People's Bank of China (PBOC) and dean of the National School of Development at Peking University, recently suggested that China should consider adopting such an inflation target. According to Huang, the Chinese economy is "easy to cool, but difficult to heat up," making it vulnerable to a "low inflation trap" with potentially serious consequences. His remarks highlight the growing concern among policymakers about the risks of prolonged deflation and the need for more aggressive measures to stimulate demand.

Why is low inflation bad?

Low inflation or even deflation can indeed seem beneficial at first glance, but it can actually pose significant problems for an economy, especially in the context of China's current economic situation. 

Here’s why low inflation is a problem and why China might need to target a higher inflation rate:

1. Deflationary spiral risk

When inflation is too low, consumers and businesses avoid spending and investment as they expect prices to drop more in the future. This leads to lower demand, which leads to companies cutting production, cutting jobs and lowering wages. This leads to more people spending less, creating a cycle also known as a deflationary spiral. 

2. Debt burden increases

Low inflation or deflation makes existing debt more expensive in real terms. When prices and incomes are not rising, the burden of debt for both consumers and businesses increases, making it harder to repay loans. China's economy is heavily reliant on debt, particularly in sectors like real estate and local government financing. If inflation is too low, it worsens the debt burden, leading to financial stress and potentially triggering defaults or a financial crisis.

3. Stagnation and economic growth

Low inflation signals weak demand and economic stagnation. In such economies businesses are likely to not invest or expand, which becomes a hurdle for growth and productivity, leading to long-term economic stagnation. 

4. Reduced effectiveness of monetary policy

Central banks typically use interest rate cuts to stimulate the economy, but when inflation is already low, interest rates are often close to zero. This limits the central bank's ability to stimulate the economy further through traditional monetary policy tools. This is why central banks often prefer mild to high inflation rather than low to nil inflation, as it is easier to bring inflation down, rather than bring it up.

The merits of inflation targeting

By aiming for a specific inflation rate, central banks can guide expectations and influence behaviour among households and businesses. For example, if people believe that prices will rise steadily at around 2%, they are more likely to spend and invest, thus boosting economic activity. In China’s case, adopting a 2%-3% inflation target could help break the current deflationary cycle and encourage consumer spending, which has been a key focus of Beijing's economic strategy. 

However, this approach is not without challenges. Central banks are supposed to be independent, a common feature in countries with inflation targets, but in the case of China is less prevalent, where political considerations often influence monetary policy decisions.

• Boosting consumer & business confidence: If businesses and consumers believe that the government will ensure inflation reaches this target, they are more likely to spend and invest now rather than waiting for prices to fall further.

  
  

• Supporting growth: A moderate inflation target encourages borrowing and spending, which can boost economic growth. It also helps reduce the real burden of debt, making it easier for businesses and households to manage their finances.

Thank you.

 Regards,

Atharva Mahadik,

Kautilya, IBS Mumbai.