When the 17th Communist Party congress convenes next month, President Hu Jintao will be confronted with some serious challenges. Foremost will be to ensure steady economic growth and price stability. Inflation is now at a 10-year high, reaching 6.5 per cent last month, as measured by the consumer price index (CPI). Actual inflation is probably much higher, given the defects of the index, which does not accurately reflect the consumption pattern of the present market-oriented system. Housing prices and other asset prices are rising at double-digit rates, but housing is underweighted. Moreover, some consumer goods are still subject to price controls. Yi Xianrong , an economist at the Chinese Academy of Social Sciences, is correct to argue that 'a CPI that is unable to accurately mirror people's consumption offers an inaccurate interpretation of the country's economic life and is also prone to leading the government, enterprises and ordinary households to erroneous decisions'. Governments often try to suppress inflation by imposing price controls. But these distort market prices, interfere with economic freedom and increase official power. Some people blame the increase in China's inflation on rising pork and other food prices. But these rises primarily reflect changes in market demand and supply, and have only a temporary effect on the price level. The National Development and Reform Commission warned local governments not to interfere with the market's setting of prices unless 'there is remarkable price growth due to emergencies or natural disasters'. But it is precisely at those times that the free market best performs its role of allocating scarce goods to their highest valued uses. Placing caps on prices of food and supplies when they become more limited will simply exacerbate shortages and corrupt markets. The poor will not be helped, but those administering the controls will gain in power. Just look at Zimbabwe. If inflation is due to an excess supply of money, then the responsibility must rest with the People's Bank of China. China's earlier bouts of double-digit inflation were clearly the result of irresponsible monetary policy, not market forces. The high inflation in the late 1980s led to price controls and shortages. Today, the central bank is more disciplined and authorities generally recognise the futility of price controls as a means of containing inflation. Is the rise in the consumer price index a monetary phenomenon or a short-term increase due to the food component of the CPI? The answer is that the food component is causing a rise in recorded inflation, but the monetary base is currently growing at 15 per cent, while 18 per cent M2 growth - a measure of the money supply - exceeds the central bank's target of 16 per cent. Excess monetary growth is being driven by China's record current account surplus and foreign direct investment. If the consumer price index understates true inflation, then real growth is overstated. With the velocity of money - the rate at which money changes hands - increasing, due to low real interest rates and inflationary expectations, the present monetary growth rate is too high to bring about long-term price stability. The real inflation rate is better indicated by sharply rising housing and asset prices than by the CPI. It is time for the central bank to stop interfering with the nominal exchange rate and let market forces set that relative price. Capital controls need to be further relaxed, interest rates need to reflect market supply and demand, and the people's bank needs to focus on controlling the supply of base money and provide for long-term price stability. If inflation is tamed and if people are free to choose without price, exchange or capital controls, markets will be better able to create the harmonious society and all-round development that China's leaders want. James Dorn is a China specialist at the Cato Institute and vice-president for academic affairs
