Summary:
From 2012 to 2016, China's CPI and PPI presented a long-term trend of deviation, clearly characterizing overall structural deflation. The long-term divergence distorted the price signal, and thus made it difficult to accurately judge the price levels and economic situation. In addition to presenting a new research problem, the divergence caused confusion in macroeconomic policy making. The traditional theories propose that there are three representative causes of deflation: a shortage of aggregate demand (Keynes, 1936), “debt-deflation” (Fisher, 1933), and monetary tightening (Friedman, 1971). However, few studies have examined the cyclical and structural factors underlying the deviation in the CPI and PPI between 2012 and 2016. In this paper, we use a combination of theoretical and empirical approaches to identify the cyclical and structural factors underlying the long-term divergence of the CPI and PPI since 2012, and analyze the causes of structural deflation in China. Based on our findings, we also provide a number of recommendations for researchers and policymakers. Following Wu and Cao (2014), we introduce the Balassa-Samuelson effect into the aggregate demand-aggregate supply model (AD-AS model), and considering the actual situation of China, further introduce external shocks, overcapacity, and other factors to better explain the mechanism of structural deflation in China. In the modeling process, we use the “general to specific method” (Hendry, 2001; Ericsson, 2007; Wu, 2014) and conduct diagnostic tests on various combinations of factors. The CPI/PPI, as an indicator of structural inflation, is used as a substitute variable for the relative price of non-tradable goods to tradable goods. Variables such as the commodity prices, economic growth, imports and exports, fixed asset investment, household income, and money supply are included as cyclical factors. Variables such as overcapacity, industrial structure, the relative labor productivity of tradable goods against non-tradable goods, corporate debt-to-asset ratio, and terms of trade are included as structural factors. All of the data are from the WIND database and the study period is from the first quarter of 2002 to the fourth quarter of 2016. The findings show that the structural deflation reflects the Chinese government's attempts to simultaneously deal with the slowdown in economic growth, make difficult structural adjustments, and absorb the effects of previous economic stimulus policies, and the risks and challenges that the economy may face. First, cyclical factors are an important cause of structural deflation in China. The weak internal and external demand and the downturn in international commodity prices had a negative shock on the CPI and PPI, although the impact was relatively short. As the domestic and foreign economies recovered and commodity prices began to rise, this negative impact was reduced or disappeared, and even had a positive impact on the CPI and PPI. Second, various structural and institutional factors are the underlying causes of structural deflation. In recent years, multiple factors, including supply-side shocks, such as the slowdown of China's labor productivity growth, overcapacity caused by the large-scale stimulus plans, insufficient domestic demand resulting from insufficient institutional reform of the housing, pension, education, and medical sectors, and the existence of the Barcelona effect, have led to an inadequate supply of high-end products and services, and a serious excess of medium and low-end industrial capacity, which have had structural and long-term impacts on deflation. To effectively resolve structural deflation, China should introduce different policy tools and accelerate the pace of the supply-side structural reforms. International experience suggests that the central bank's ability to implement expansionary and tightening monetary policies is asymmetric. In the case of structural deflation, the efficiency of monetary policy is often greatly reduced due to the risk control of commercial banks and the changing expectations of the currency holders. Under these circumstances, an excessively loose monetary policy will not benefit capacity clearing, and may lead to a new round of asset price bubbles. In the new normal of the economy, the regulatory effects of aggregate demand and supply appear to be asymmetric. In the future, while maintaining a prudent and neutral aggregate policy stance and managing aggregate demand, China should pay more attention to supply-side reforms by introducing policies to optimize the market structure, improve the supply side environment and mechanism, stimulate the vitality of micro subjects, comprehensively improve the total factor productivity, and realize the market clearing of overcapacity and the optimal adjustment of the economy. It is also necessary to continuously track the factors related to structural deflation and the evolution trends at home and abroad. This will require new innovative research methods and further theoretical and policy related research.
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