When up is down

Few things stick in an economist’s craw more than the common use of the expression, “food price inflation.” In China people are using this term regularly to describe the increase in the consumer price index (CPI) caused by the increase in food prices. However, inflation is the synchronized and proportionate increase in all prices and wages, and this is not what China is experiencing.

Food prices are rising relative to the prices of all the other goods and services in the economy. This is a microeconomic problem, not the macroeconomic phenomenon known as inflation. The differences are more than just semantic: An undesired rise in food prices relative to other prices in the economy is in many ways more unpleasant than inflation, and requires a very different policy response.

A food price increase is, in most cases, deflationary – not inflationary – for the economy. Suppose the demand for food is price inelastic, meaning that increases in prices do not reduce the amount of food that you buy. People, after all, have to eat. The amount of food a middle-income or richer household buys is not going to vary much if prices go up. A rise in food prices means that the total amount of income spent on food goes up.

If wages and disposable income do not increase with food prices, then the amount of money left over to spend on other goods and services – after the household bellies have been filled – is reduced. Prices in the non-food sector are held back by a drop in the volume of demand for those goods and services. This is deflationary.

Unequal burdens

Things are worse for extremely poor households, living at or near the subsistence level of income. As recently as five years ago, World Bank statistics showed 250 million people in China living on incomes of less than $1 per day. More recent estimates put between 13% and 17% of China’s population of 1.3 billion people living on less than the purchasing power equivalent of US$1 per day. They do not consume a lot of other discretionary goods and services, so they have no scope to cut spending on non-food items.

It is also worth noting that food prices have risen 5.9 percentage points faster than non-food prices, on average, over the last decade. In a sense, this has contributed to widening the gap between the real disposable incomes of the rich and the poor in China. Rich households spend less of their total nominal incomes on food, while poor households spend almost all of their earnings on things to eat. For the poorest people, higher food prices mean less to eat. This is a basis for social unrest, which the government wants to avoid at any cost. Food policy matters to social stability, as well as to GDP growth.

Thus, I expect the government to move quickly to raise the supply of food. The fastest way to do that is to import a lot of foodstuffs, and quickly. China has invested heavily in agricultural resources in South America, especially in farmlands producing rice, soybeans and wheat. Now is the time to engage those resources in the national interest. In the latest month reported, grain prices were up 14.7% in the 12 months ended November.

We should not be surprised to see China’s interests appearing in size on the world market for grains, further boosting prices that are already going up quickly. Food imports may trim back the trade surplus a little bit, too, something everyone would welcome. Fish prices were 11.9% higher than a year ago in November; vegetable prices were up 21.3%, eggs 17.6% and fruits 28.1%. These foods are usually produced locally and they are hard to import. Policies to boost production are needed. Non-food prices are only 1.9% higher than a year ago, which is well below historical norms and nothing to worry about.

Forget rate hikes

An increase in interest rates is not the right antidote for China’s CPI increase. No interest rate in the world can move the price of rice in China very much. The government is also well-advised not to revalue the renminbi to resolve this domestic supply issue: That will not help. It has to concentrate on food policy – a microeconomic policy – because it affects just one sector of the economy.

As for the macroeconomic challenge of minimizing inflation risks in the longer term, money supply growth has been slowing steadily over the last half year. Over time, inflation requires an accommodating increase in the money supply. Recent increases in the banks’ required reserve ratios were implemented to rope in money and credit growth at the end of last year. As a result, growth of money and credit ended last year at sustainable levels after half-a-year of imprudently fast growth.

The People’s Bank of China (PBoC) did raise both deposit and lending rates in December. This was, in my view, a reaction to market conditions and not a direct move to counter inflation. As the PBoC raised the reserve requirement ratio in 2010, forcing banks to hold onto a higher percentage of reserves, the interbank money market rate soared near the end of the year. Loans of reserves from bank to bank increasingly are the marginal source of funds to the banking system, and they became scarce. Banks could not make a profit on marginal loans funded on the interbank market at posted lending rates: Something had to give, and the PBoC helped avoid a total credit crunch by raising lending rates.
Now that the new year – and new reserve period – has begun for the banking system, interbank funding rates have dropped to 3.6% from over 6% in mid-December. Banks will find lending very profitable in 2011 at elevated lending rates. The resulting surge in lending will be the PBoC’s next challenge, unless it keeps money markets snug with more increases in reserve requirements.

This, rather than interest rate increases, will be the weapon of choice when trying to throttle credit growth. The PBoC has already raised its reserve requirement once this year, to 19% from 18.5% with effect on January 20. There always is a risk of inflation in any economy – so the central bank wants to keep both money and credit under control. While growth of money is necessary for inflation to occur, excessive expansion is not sufficient to cause inflation on its own.

Deflationary increases

If it vexes you that a 5.1% rise in the CPI over a year is not inflation, then consider the following: The CPI is calculated as the price of a fixed basket of goods and services, and the weights of all the goods and services in that basket never change. When all prices rise – true inflation – the CPI goes up. However, a big increase of only a handful of goods – a relative price shift – can also raise the CPI. Inflation always causes the CPI to rise, but not all increases in the CPI are inflation. This is something economists learn in school but often forget. Ponder that before you predict big interest rate increases for China this year.

China’s policy makers seem to understand this a lot better than teenaged scribblers in the West. In a prominent story in late November, the People’s Daily reported that the State Council had announced measures “to rein in rising commodity prices to ease the economic pressures on the people.”

It continued: “Local governments and departments are required to boost agricultural production and stabilize supply of agricultural products and fertilizer while reducing the cost of agricultural products and ensuring coal, power, oil and gas supplies, the State Council said in a seven-page circular. Local governments must also temporarily disburse subsidies, the circular added.”

Ominously, in my view, the People’s Daily also noted that local authorities were ordered to establish “coordinated social-security mechanisms that promise a gradual rise in basic pensions, unemployment insurance and minimum wages.”
The way you turn a relative price change into real inflation is to index
wages to specific prices in the economy. That opens the door to a wage price spiral that can spin out of control. This is what happened in the 1970s in the major industrialized economies.

Back then, workers in most economies had their wages indexed to the CPI to protect real incomes from inflation. When oil, food and industrial commodity prices jumped in the early 1970s, they pushed up the CPI mechanically, even though only a few prices in the basket were rising.

The rise in the CPI triggered an increase in wages, which in turn boosted unit labor costs. Wages are 85% of the cost of producing everything in the economy, so the wage increases forced companies to raise prices to maintain profits.
Suddenly, all prices were increasing because of the push up in costs from rising – indexed – wages. The absence of wage indexation in today’s economies is what breaks the inflation spiral before it can get started.

While Beijing wants to protect the real spending power of the people, it is ill-advised to use wage increases linked to food price increases to do so.