PBoC governor Zhou Xiaochuan should give Jeff Frankel a call (he is welcome to call me as well)

Jeffrey Frankel of course is a long-term advocate of NGDP targeting, but recently he has started to advocate that if central banks continue to target inflation then they should target producer prices (the GDP deflator) rather than consumer prices. As anybody who reads this blog knows I tend to agree with this position.

Jeff among other places has explained his position in his 2012 paper “Product Price Targeting—A New Improved Way of Inflation Targeting”In this paper Jeff explains why it makes more sense for central banks to target product prices rather than consumer prices.

Terms of trade volatility poses a serious challenge to the inflation targeting (IT) approach to monetary policy. IT had been the favoured monetary regime in many quarters. But the shocks of the last five years have shown some serious limitations to IT, much as the currency crises of the late 1990s showed some serious limitations to exchange rate targeting. There are many variations of IT: focusing on headline versus core CPI, price level versus inflation, forecasted inflation versus actual, and so forth. Some interpretations of IT are flexible enough to include output in the target at relatively short horizons. But all orthodox interpretations focus on the CPI as the choice of price index. This choice may need rethinking in light of heightened volatility in prices of commodities and, therefore, in the terms of trade in many countries.

A CPI target can lead to anomalous outcomes in response to terms of trade fluctuations. Textbook theory says it is helpful for exchange rates to accommodate terms-of-trade shocks. If the price of imported oil rises in world markets, a CPI target induces the monetary authority to tighten money
enough to appreciate the currency—the wrong direction for accommodating an adverse movement in the terms of trade. If the price of the export commodity rises in world markets, a CPI target prevents monetary tightening consistent with appreciation as called for in response to an improvement in the terms of trade. In other words, the CPI target gets it exactly backward.

An alternative is to use a price index that reflects a basket of goods that the country in question produces, including those exported, in place of an index that reflects the basket of goods consumed, including those imported. It could be an index of export prices alone or a broader index of all goods produced domestically. I call the proposal to use a broad output-based price index as the anchor for monetary policy Product Price Targeting (PPT).

It is clear that Jeff’s PPT proposal is related to his suggestion that commodity exporters should target export prices – what he calls Peg-the-Export-Price (PEP) and I have termed the Export Price Norm (EPN). A PPT or PEP/EPN is obviously closer to the the Market Monetarist ideal of targeting the level of nominal GDP than a “normal” inflation target based on consumer prices is. In that regard it should be noted that the prices in nominal GDP is the GDP deflator, which is the price of goods produced in the economy rather than the price of goods consumed in the economy.

The Chinese producer price deflation

The reason I am writing about Jeff PPT’s proposal this morning is that I got reminded of it when I saw an article on CNBC.com on Chinese producer prices today. This is from the article:

The deflationary spiral in China’s producer prices that has plagued factories in the mainland for 16 consecutive months highlights the weakening growth momentum in the world’s second largest economy, said economists…

…The producer price index (PPI) dropped 2.7 percent in June from the year ago period, official data showed on Tuesday, compared to a fall of 2.9 percent in May. Producer prices in China have been declining since February 2012, weighed down by falling commodity prices, overcapacity and weakening demand.

…China’s consumer inflation, however, accelerated in June, driven by a rise in food prices.

China’s consumer price index (CPI) rose 2.7 percent in June from a year earlier, slightly higher than a Reuters forecast of 2.5 percent, and compared to a 2.1 percent tick up in the previous month. However, June’s reading is well under the central bank’s 3.5 percent target for 2013.

This I think pretty well illustrates Jeff’s point. If the People’s Bank of China (PBoC) was a traditional – ECB style – inflation target’er focusing solely on consumer prices then it would be worried about the rise in inflation, while if the PBoC on the other hand had a producer price target then it would surely now move to ease monetary policy.

Measuring Chinese monetary policy “tightness” based on PPT

In the pre-crisis period from 2000 to 2007 Chinese producer prices on average grew 2.3% y/y. Therefore, lets say that the PBoC de facto has targeted a 2-2.5% level path for producer prices. The graph below compares the actual level of producer prices in China (Index 2000=100) with a 2% and a 2.5% path respectively.  We can see that producer prices started to decline during the second part of 2011 and dropped below the 2.5% path more or less at the same time and dropped below the 2% path in the last couple of months. So it is probably safe to say that based on a PPT measure Chinese monetary policy has become tighter over the past 18 months or so and have become excessively tight within the last couple of quarters.

PPI China

The picture that emerges from using a ‘Frankel benchmark’ for monetary policy “tightness” hence is pretty much in line with what we see from other indicators of monetary conditions – the money supply, NGDP, FX reserve accumulation and market indicators.

It therefore also seems fair to say that while monetary tightening probably was justified in early 2010 one can hardly justify further monetary tightening at this stage. In fact there are pretty good reasons – including PPT – that Chinese monetary policy has become excessive tight and I feel pretty confident that that is exactly what Jeff Frankel would tell governor Zhou if he gave him a call.

Leave a comment


  1. James in London

     /  July 9, 2013

    Poor old Zhou. He has a tremendous problem if he should be lossening monetary policy in the face of a runaway credit boom.

    The answer would be to deregulate interest rates and let the shadow banking/black market rate of 9% come down to meet the official rate that should go up. More than half the credit growth in China in the first five months was in the shadow banking sector, itself growing at 60%+ YoY, vs 15% in the official sector.

    A 25%+ Total Social Financing growth YTD is a lot for an economy growing at 10% NGDP to bear. What would you suggest Zhou should do given these additional facts?

    • James,

      I think it is pretty simple – monetary policy should be focused on monetary matters. Chinese monetary policy is clearly becoming too tight and monetary easing is badly needed.

      I suspect that the credit boom is not necessarily a result of monetary policy, but rather a result of failed government planning, housing subsidies, implicit and explicit state guarantees and general problems with moral hazard. That needs to be taken care off by deregulation of the financial sector and a general freeing up of investment decisions. Many investments decisions in China is still massively distorted by direct or indirect government interference. Monetary policy cannot deal with these issues and if central bankers get themselves preoccupied with credit issues then it is pretty certain that the wrong decisions will be taken.

  2. I think PPT does not make sense in a such big and relative closed economy like China, but it would make sense in countries like Singapore, Sweden or Switzerland.
    You got to understand the difference between PPI input (purchaser prices) and PPI output (producer prices) http://www.stats.gov.cn/english/pressrelease/t20130709_402909717.htm Then you understand that the whole y/y change was caused by cheaper purchases. Cheaper input prices are again caused weaker factor/commodity prices and the stronger yuan. On the other side, producer prices for consumer goods are unchanged y/y.

    With PPT you would question the whole transformation process of the Chinese economy. For more consumption, the bank needs weak inflation, 2.7% CPI is still quite high.

    Before Zhou Xiaochuan speaks to guys like Frankel or you, he should quickly check with party leader Xi Jinping, if he is allowed to listen what you guys say.

  3. Just one thing about “monetary tightening in early 2010”.

    For me the global recession took only one year from 2008 to 2009. Thanks to the Chinese government stimulus program the world economy could quickly expand again. PPI values of 5-6% in 2010 were justified when compared to the recession year 2009 with minus 7% PPI.

    Tightening in 2011 would have worked well if there was not “helicopter Ben” that was flooding the world with money in QE2 and causing the currency wars. Similar as Brazil’s Mantega, the PBoC should have tightened shortly after the QE2 announcement.
    But they were too optimistic and thought that QE2 would not drive up commodity prices excessively and with it the PPI to +6% and more in 2011.

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