Inflation Uncertainty and Monetary Policy in China

This paper uses a stochastic volatility model, structural break tests with unknown point, and a counterfactual simulation method to discuss the significant decline in inflation uncertainty in China over 1978-2009. We attempt to quantify the contributions of better monetary policy and smaller structural shocks (including demand, supply and policy impacts) on the reduced inflation uncertainty. Empirical results in the present paper suggest that improved monetary policy accounts for only a small fraction of the reduction in inflation uncertainty from the pre-1997 period to the post-1997 period in China. The bulk of the significant moderation in inflation uncertainty arises from smaller shocks. This finding indicates that the quiescence of inflation in China over the past decade could well be followed by a return to a more turbulent inflation era. Therefore, the use of preemptive monetary policy to anchor inflationary expectations and keep moderate inflation uncertainty is warranted.