On Containing Inflation

This post draws significantly from M. Pettis.

"Raising interest rates should encourage depositors to hold more money in their savings accounts." This is a very U.S. centric view of how financial systems translate changes in interest rates into changes in savings rates, via changes in household wealth.

It is hard to understand why China has such a high savings rate with such low real deposit rates. Negative real interest rates actually reduce household wealth by reducing the value of savings. Few households in China borrow and few households hold assets whose value benefits from declining interest rates (which is the opposite of the US).

So raising real interest rates (NOT NOMINAL) would in fact be inflationary by increasing household wealth, and thus reducing their incentive to save money.

Inflation reduces the value of household savings and reduces consumption, which is a self correcting measure for inflation.

The bad news is China's (Asian) financial system doesn't just counter act CPI inflation, it converts it into asset price inflation. This is a real concern in an economy that is likely misallocating capital. China's economy is dependent on expanding credit to fund investment. Raising interest rates by 25 (or 100bps since Nov?) are far too low to have a meaningful impact on credit supply. Reducing the flow of credit through PBoC sterilization, the flow of government deposits, Required Reserve Ratios, and reduced shadow banking credit, quickly translates into economic pain.