This article is part of Macro Hive’s 2025 Grey Swan series, where we let our imaginations loose to try and predict low-probability, high-impact events that almost no one expects. You can read the full list here.
Dragon Years With Mixed Feelings
The Dragon symbolizes power and holds an esteemed place in Chinese culture. Yet Chinese people have mixed feelings about Dragon years, which come around every 12 years according to the Chinese zodiac. Many associate these years with disaster due to historical events like the Tangshan earthquake in 1976 and the mythology that dragons are linked to water and weather, which can cause natural disasters like floods and typhoons.
Many investors may also remember 2024 – a Dragon year – with mixed feelings. Sentiment swung from ‘anything but China’ (ABC) to ‘buy everything related to China’ and back. And we will likely end this year with four consecutive quarters of negative GDP deflator (after three quarters last year) with no quick return of the ‘animal spirit’ in sight.
Perhaps the Dragon year lived up to its own ‘self-fulfilling prophecy.’ However, Chinese policymakers must accept some of the blame for not taking the inflation goal seriously and preventing the economy from entering a self-fulfilling low-inflation trap.
Managing Inflation Expectations
China’s annual Two Sessions sees the State Council announce the year’s goals, including CPI. While seldom missing the GDP and job creation goals, the government has not achieved the inflation goal since 2012. For the People’s Bank of China (PBoC), the foremost mandate of ‘maintaining currency stability’ also focuses on external rather than internal value based on our perception.
However, the PBoC has just suffered seven consecutive quarters of deflation and intensifying warnings from domestic economists. And as such, in November, it changed the Q3 Monetary Policy Execution Protocol regarding inflation from ‘keeping prices at reasonable levels’, used in the previous two years, to ‘promote the maintenance of prices at reasonable levels.’
But what could that entail? If we turn to Japan, we may find an answer.
In January 2013, Japan’s government and the Bank of Japan (BoJ) jointly declared a 2% inflation target, promising to achieve this in two years. In the following two years, the Japanese GDP deflator recovered, and it entered positive territory for the first time in 2014 after 18 consecutive quarters in negative territory. Even if there were setbacks in 2017 and 2018, Abenomics with an ultra-lose monetary policy freed Japan from the ‘lost two decades.’
Now, highly respected local economists are demanding the PBoC declare an inflation target to stabilize inflation expectations, following Japan’s example.
Based on a 2023 PBoC-affiliated publication that accurately predicted 2024’s monetary policy framework reform, the PBoC would only launch an inflation target in five years (or three years from now). But given the stickiness of the deflation since late 2023, could the PBoC and the National Development Reform Commission (NDRC) jointly declare a 3% inflation target for 2025? That is our Grey Swan.
Snake Years of Wisdom and Transformation
So how would an inflation target play out?
When Japan declared one, it significantly impacted the currency and equity markets. From January 2013 to January 2016, before the BoJ cut the target rate below zero, JPY depreciated 37% against USD, and the Nikkei rose 61%.
A PBoC declaration of an inflation target would also clearly signal that monetary policy will focus more on domestic issues than external valuation. However, how the currency and equity market will react will still depend on the NDRC’s plan to achieve the inflation target.
If the push for demand is biased toward government-led investment, either infrastructure or production capacity, the market can react adversely to the announcement. Japan’s experience shows that sustainable inflation recovery is impossible without the real economy participating. This means improving private companies’ confidence and households’ income.
The PBoC has positively surprised the market multiple times this year. We expect more next year (year of the Snake). Unlike dragons, snakes in Chinese mythology are not associated with power and strength, but snakes’ adaptability makes them a symbol of wisdom.