China’s Spotty Record on Inflation Targeting

Nicholas Borst (Federal Reserve Bank of San Francisco)



Given that the People’s Bank of China (PBoC) is not an independent central bank, monetary goals such as inflation and credit targets are formulated by the State Council. The central bank is then tasked with implementing these goals. Each spring at the National People’s Congress, the premier gives a speech outlining the important economic goals for the year. Among these goals is a target increase in consumer prices, i.e. inflation. Controlling inflation is an important goal in any economy, particularly so in China where high inflation is linked to social instability.

Each month when the new consumer price index number is released analysts refer back to the inflation target as a check on the performance of the central bank.  So how well does the PBoC do in meeting the inflation goals set out for it? The answer is not very well in most years.  Over the past eight years, the PBoC has missed its inflation target by an average of 1.8 percentage points.

Year Inflation Target Annual CPI Difference btw Target and Actual One-Year  Benchmark Deposit Rate*
2013 “around 3.5%” 2.42% (1H) 1.08% (1H) 3.00% (1H)
2012 “around 4%” 2.60% 1.40% 3.23%
2011 “around 4%” 5.40% -1.40% 3.29%
2010 “around 3%” 3.30% -0.30% 2.33%
2009 “around 4%” -0.70% 4.70% 2.25%
2008 “around 4.8%” 5.90% -1.10% 3.80%
2007 “3.0% or less” 4.80% -1.80% 3.29%
2006 “controlled at 3%” 1.50% 1.50% 2.36%
2005 “controlled at 4%” 1.80% 2.20% 2.25%

*Average of the twelve monthly rates during the year in question

This number should give pause to central bank watchers who assign a high degree of accuracy to China’s inflation targets. Managing inflation, especially in a developing economy, is a tough business. The tools the PBoC has at its disposal to manage price increases are imprecise at best.

This is also important to keep in mind with respect to the PBoC’s recent effort to guide interest rates in the interbank market. Concerned about the fast growth of credit in first half of 2013, the PBoC attempted to reign in easy money in the interbank market, forcing rates higher by refusing to add liquidity. Unfortunately, what was probably designed as a gentle lesson turned into a multiday liquidity crunch that spooked investors worldwide. Achieving a target interest rate, whether its annual consumer inflation or the overnight borrowing rate, is often easier said than done. Analysts often overestimate the PBoC’s precision in guiding the economy.

The other interesting thing about the inflation targets set by the State Council is that with the exception of one year, the annual inflation target has been set above the average benchmark rate on one-year deposits. For these years it was the explicit government policy for banks to pay deposit rates lower than the rate of inflation. As we've mentioned before, negative real interest rates are at the heart of many the distortions in the Chinese economy. Setting the benchmark rate below the inflation target confirms that this was by design rather than by accident.

As China considers moving forward with financial reform this year, setting deposit rates at a healthy level above expected inflation should be a key goal. This is a basic necessity to increase the income of China’s savers, especially those without access to sophisticated alternatives to savings deposits.  Until that happens, the large and regressive transfer from ordinary savers to banks and corporate borrowers will continue.

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