Inflation persistence, inflation expectations, and monetary policy in China

Abstract

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.