The problems of inflation and asset bubbles are now on the back of every investor’s mind. The recent series policy tightening has certainly heightened the perceived policy risk in China, which has weighed on stocks and commodities markets.
Despite a “low” inflation number of 4.4% (compared to 13% in the United States back in 1979), the problem might be so hard to control. As I written previously, in order to avoid the Chinese Yuan appreciation, the money supply growth in China has gone out of control:
I am perfectly aware that the situations China in 2010 and the United States in 1979 would not be comparable in many ways. It might be instructive, however, to take a look how the Federal Reserve back then effectively engineered two recessions to bring inflation under control.
The former Fed Chairman Paul Volcker was widely credited as the one who ended the period of high inflation. Although the money supply growth in the United States was relatively fast in the 1970s (roughly at a low double-digit rate), it was still much slower than that of China in the past few years (e.g. the year-on-year change of M2 money supply hit almost 30% on November 2009). Nevertheless, Inflation was a serious problems back then with increasing oil prices fuelling a double digit inflation. On 6 October 1979, an emergency FOMC meeting was held, shifting policy focus from the Fed funds rate to money supply growth and allowing the Fed funds rate to swing in a much wider range in order to stop money supply from growing too fast. On 22 Oct 1979, less than a month after that meeting, the effective Fed funds rate hit 17.60%, 5.99% higher than the day prior to the meeting. Later in 1980, the Fed also imposed control on credit expansion by restricting banks’ loan growth. This made the Fed funds rate rose further to 19.85% on 31 March 1980. These produced a short recession immediately.
The Fed continued to get tough on inflation after the first recession, making interest rates swung to even higher than the previous peak. It eventually created another recession, which was even deeper. After this deep recession, however, inflation finally dropped to a low single-digit level, and never quite returned for the next 2 decades. So the period of high inflation ended after a period of retrain of money supply growth (among many other reasons, such as drop in oil prices).
So the Fed’s focus on money supply growth made large swing in interest rate, and upswing of it caused two recessions. Truth be told, the money supply growth before Paul Volcker’s tenure was still slow relative to what we see now in China, and the decrease in money supply growth rate in the United States was actually not very dramatic. But you will probably have to expect a different story if China wanted to learn from Paul Volcker.
If the Chinese authority is really serious about inflation and bubbles, there will be a hard choice to make. Given the large increase in money supply and expansion of credits over the past years, we have good reasons to believe that inflationary pressure is enormous (so enormous that we have good reasons to doubt if the authority is understating the number). Given the latest year-on-year change of M2 money supply at almost 20%, if the government is serious about inflation, they probably have to slow the growth rate at least to low double-digit region, which is a very big cut in growth rate.
To tighten that much, it will have to mean that Chinese Yuan has to be allowed to appreciate much more quickly, and interest rate has to be allowed to increase sharply. There will be, however, serious repercussion. Exporters will be hurt, credits conditions will deteriorate, home prices will drop… I trust I don’t need to continue describing it, and you know what I mean. Yes, recession. A very deep one indeed.
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