China should set an explicit goal of low inflation to provide an anchor for monetary policy as it gradually adopts a more flexible exchange rate, according to a new International Monetary Fund Working Paper.
The proposal stops short of formal inflation-targeting.
But its consequences are still far-reaching, entailing operational independence for the central bank and transforming China's banks into genuinely commercial lenders that are financially robust enough to withstand the sharp interest rate swings that might be needed to maintain price stability.
"We believe that reforms could be put in place in the next few years to achieve these ends and serve as an adequate foundation for independent monetary policy," the paper says.
The authors of the paper are Marvin Goodfriend, a former Federal Reserve Bank of Richmond vice-president and now a professor at Carnegie-Mellon University, and Eswar Prasad, head of the financial studies division in the IMF Research Department.
The choice of a new nominal inflation anchor and monetary policy framework is pressing because China is abandoning the fixed exchange rate that has hitherto tied its hands.
"A flexible, independent monetary policy oriented to domestic objectives is fast becoming indispensable for the effective management of the Chinese economy," Goodfriend and Prasad say.
They do not advocate a full-fledged inflation targeting regime but say China should announce in the near future its intention to lock in the current low inflation rate indefinitely.