Painful inflation lessons for the United States and China

Much to the chagrin of party officials, China’s inflation rate rose by 0.4 percent in January, ending a much-needed five-month drop in the rate. While commentary has rightly noted that the rise in prices is largely due to holiday shopping, the continued volatility of China’s inflation rate has to be a concern. As the chart below shows, inflation levels have been elevated since 2007, and the range in which inflation varies is more than twice that of the decade prior.

The most pressing problem of the volatility is the problem presented to lower class Chinese families who are trying to plan for basic cost-of-living expenses like food and shelter. The lack of price stability has exacerbated the political tensions surrounding Chinese economic inequality, a problem so large that it led the Chinese government to reduce income taxes to zero for millions of low-income Chinese taxpayers last spring. Party higher-ups have made it clear that economic inequality will continue to be a focus of China’s economic development as they maintain their push to create a stable middle class.

More instructively, the volatility underscores the warnings issued by certain U.S. policymakers regarding the Pandora’s box of unanchored inflation expectations. Some Fed officials and members of Congress have mounted an offensive to dissuade the Fed from its hyper-focus on price stability, relying on the notion that a trade-off between inflation and unemployment could help our abysmal job numbers.

The problem is that unanchored expectations are hard to re-anchor, and, as the Chinese are learning, regaining an environment of low and steady inflation can be painful. Or, as Paul Volcker pointed out in September:

… the danger is that if, in desperation, we turn to deliberately seeking inflation to solve real problems — our economic imbalances, sluggish productivity, and excessive leverage — we would soon find that a little inflation doesn’t work. Then the instinct will be to do a little more — a seemingly temporary and “reasonable” 4 percent becomes 5, and then 6 and so on.

What we know, or should know, from the past is that once inflation becomes anticipated and ingrained — as it eventually would — then the stimulating effects are lost. Once an independent central bank does not simply tolerate a low level of inflation as consistent with “stability,” but invokes inflation as a policy, it becomes very difficult to eliminate.

It is precisely the common experience with this inflation dynamic that has led central banks around the world to place prime importance on price stability. They do so not at the expense of a strong productive economy. They do it because experience confirms that price stability — and the expectation of that stability — is a key element in keeping interest rates low and sustaining a strong, expanding, fully employed economy.

The Fed may not be perfect, but its emphasis on price stability is well-founded. China’s painful experience should only serve as a reminder to meddlesome congressmen and dissenting Fed presidents.

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