Why Chinese central bank should focus on headline inflation

Abstract

In this paper, we explore the change in short-term headline-core inflation dynamic relationship using threshold error correction model, and explain why the Chinese central bank should focus on headline inflation when conducting monetary policy. The results find that: (1) the deviation between core and headline inflation is eliminated mainly through reverting core inflation to headline inflation in high inflation period, indicating that headline inflation catches the long-term trend of inflation much better than core inflation does; (2) movements in food price have become a significant source of public’s inflation expectations and food inflation persistence is increasing, reflecting that the rising food price may not have been a transient phenomenon but has become a part of the long-term trend of inflation. The above conclusions imply Chinese central bank should not implement the monetary policy based on core inflation excluding food price but should make a certain response to the surging food price.