Inflation persistence, inflation expectations, and monetary policy in China

a r t i c l e i n f o This paper constructs a quarterly series of GDP deflator inflation for China from 1979 to 2009 and tests for a structural break with an unknown change point in the dynamic inflation process. Empirical results suggest a significant structural change in inflation persistence. Employing a counterfactual simulation method, we show that the structural change is primarily attributed to better conduct of monetary policy and the resultant better anchored inflation expectations. This finding implies that the quiescence of inflation in China over the past decade could well be followed by a return to a high inflation era in the absence of a determined effort by the monetary authorities in managing inflation expectations. Therefore, the use of a preemptive monetary policy to anchor inflationary expectations and to keep inflation moderate is warranted in China. Since 1979, China has witnessed remarkable changes in the pattern of its inflation process. In particular, the rate of inflation in China is now much lower and less volatile than it was in the 1980s and early 1990s. This change coincides with China's monetary policy reforms since the late 1990s. Significant examples of these reforms include establishments of interbank money markets and bond markets in 1995–1996 and commencement of open market operations in 1998, through which China has changed its monetary policy from direct credit quota control to indirect adjustment with both quantity-and price-based instruments. These shifts in monetary policy may have induced major structural changes in the dynamic models of the inflation process, as articulated in the famous Lucas critique (Lucas, 1976). In the context of the Chinese economy, these important changes in monetary policy may have induced structural instability in the dynamic process of inflation, and in particular the persistence of inflation. That is, the change in inflation dynamics could reflect the fundamental shift in monetary policy whereby the PBOC now systematically acts to stabilize inflation around a potential long-run target and has gained credibility with the public that it will continue to do so into the future. Surprisingly, relatively little effort seems to have been devoted to testing the empirical importance of the Lucas critique in terms of China's inflation dynamics and monetary policy. The existing literature focuses particularly on issues relevant in the United States, while little consensus has been achieved. For instance, Estrella and Fuhrer (2003) and Rudebusch (2005) assess the empirical importance …