Recent disinflation is consistent with lower growth and symptomatic of a deeper-rooted issue of insufficient demand
China’s inflation has declined sharply since 2011. Consumer-price rises averaged 4.4% in 2010-11 but only 2.2% in the year to September 2014. Seasonal food prices can spike – pork and fresh produce can jump up to 20% year-on-year – but the trend in the decline shows a more structural issue. It demonstrates a lack of demand-pull inflationary pressure.
As many heavy industrial sectors are in overcapacity – the State Council has identified 10 such sectors – pressure to cut prices is severe. These issue of ‘too much spare capacity’ or ‘too little demand’ is even more prominently reflected in producer-price inflation, which has fallen from 5.8% in 2010-11 to an annual average -1.8% since 2012. Commodity prices do not explain all of the decline.
There is a trade-off between growth and inflation over the 14 years for which we have quarterly data. Normally, faster growth generates upward inflation, and vice versa. If the disinflation trend were purely an inflation problem, not a demand-side problem, there would be a divergence between growth and inflation, but this has not been the case.
The recent disinflation is consistent with lower growth and symptomatic of a deeper-rooted issue of insufficient demand. The Chinese economy expanded by 7.3% in the third-quarter of 2014. Although domestic demand has stabilised, apart from one quarter in 2009, during the financial crisis, that is the slowest growth in the nearly 14 years of available data.
Thus, we think growth has slowed more than it needs to – more than is necessary to contain inflation or other signs of overheating. Data show an obvious investment slowdown, but inflation has shown the clearest sign that demand has slowed too much relative to supply.
Both the trend in inflation, as well as its consistency with weaker GDP, suggest the problem is more than base effect and transitory supply shocks. A more fundamental factor – the gap between supply capacity and effective demand – is at play.
This ‘spare capacity’ is reflected not only in falling inflation, but also in weak capacity utilisation and labour-market slack.
Labour-market slack has often been missing in the discussion about growth. Not only is there a shortage of data, especially monthly or quarterly figures, there has been too much focus on how many jobs are created every year, not whether this includes replacement or, more importantly, how big the labour supply is.
However, the Purchasing Managers’ Index shows continued job shedding in manufacturing since 2012 and the larger services sector has not been able to offset this completely. Meanwhile, wage growth has slowed and more than 7m new graduates will enter the job market in 2014.
As inflation, capacity utilisation and the labour market all point to insufficient demand, we think there is a clear case for counter-cyclical policies. Monetary policy may need to be more active, with the central bank promoting reasonably-priced lending to boost demand. But fiscal policy and reform measures may also play a counter-cyclical role: infrastructure investment, tax cuts and streamlining the government have all helped to support economic activity so far in 2014.