Imagine a 4% inflation target – this year’s Chinese inflation target – trend real GDP growth 10-11% and money-velocity growth between -1% and 0% then the money supply (M1) should grow by 15-16% to ensure the inflation target in the medium term. This is more or less a description of Chinese monetary policy over the past decade.
Over the past decade People’s Bank of China has been targeting M1 (and M2) growth exactly around 15-16% (give and take a bit…). Overall the PBoC has managed to hit its money supply target(s) and that has more or less ensured nominal stability in in China over the past decade.
I find it useful to track the growth of M1 versus two idealized targets path of 15% and 16% going back to 2000. This is my favourite graph for the Chinese economy. See here:
From 2000 to 2008 M1 grew more or less in line with the 15-16% idealized paths. However, when the global crisis hit in late 2008 the PBoC reacted to the drop in velocity caused by the crisis by stepping up monetary easing and M1 growth accelerated dramatically.
This obviously is contrary to what happened in the US and the euro zone and this in my view is why the crisis was so relatively short-lived and benign in China.
However, the PBoC might have overdone it a bit on the “easy side” and that might have contributed to the formation of certain bubbles in the Chines economy and we all know the stories of Chinese “ghost cities”.
The PBoC undoubtedly has been aware of the risks associated with the monetary easing after 2008 and this undoubtedly is the key reason why the PBoC in 2010 started to slow money supply growth.
Given the speed of the slowdown from nearly 40% M1 growth at the peak in 2010 to less the 5% earlier this year it is hardly surprising that the Chinese economy has slowed quite a bit since 2010. Despite the sharp slowdown in M1 the PBoC has been reluctant in restarting money easing and M1 is still well below the 15-16% pre-crisis growth rates. However, as the graph shows the actual level of M1 is now back within the 15-16% path range and the PBoC therefore should no longer worry that it’s 4% inflation target will be jeopardized.
The PBoC might of course begin to suffer from the same bubble-scare that both the ECB and the fed suffered from in 2008 and that might of course postpone monetary easing, but a simple monetary analysis shows that there would be little medium-term inflation risks if the PBoC would bring back M1 to the 15-16%. For the sake of the global economy we can only hope that the PBoC is more monetarist than the their colleagues in the ECB and the fed.
PS from a Market Monetarist perspective we should note that the Chinese stock market has outperformed the global markets recently. That is an indication that Chinese monetary conditions indeed are getting easier. The September M1 and M2 data tell the same story.