Inflation and China's monetary policy reaction function: 2002-2013

Our paper attempts to enhance the understanding of China's monetary policy rule, which may help explain the country's remarkable inflation performance over the past decade, in spite of the absence of explicit inflation targeting. In particular, we aim to shed light on the role of inflation in the conduct of monetary policy by the People's Bank of China (PBC) in the New Millennium, when both the underlying economy and its monetary policy framework were transformed. We develop a new monetary policy index (MPI) in China by combining quantity, price and administrative instruments and estimate a hybrid (backward- and forward-looking), dynamic, discrete-choice model for the period 2002–13. Three main results arise from the paper. First, the Chinese monetary policy changes under PBC Governor Zhou from 2002 onwards have been relatively hawkish and smoothed. Second, the PBC appears to have built up a monetary policy framework similar to implicit flexible inflation targeting, with a hybrid reaction function, seemingly taking into account the forward-looking aspect of inflation. Third, the PBC's behaviour post-2002 resembles that of the post-1979 anti-inflation policy of the G3 central banks, albeit with a high output weight typical of emerging economies.