What's the PBOC's Optimal Monetary Policy in Response to the Fed Interest Rate Hikes?

With the world's two largest economies so closely involved, how should China’s central bank respond to the Federal Reserve's move toward long-term rate hikes?

Karen Liu
    Jan 28, 2018 6:05 AM  PT
What's the PBOC's Optimal Monetary Policy in Response to the Fed Interest Rate Hikes?
author: Karen Liu   

In its last meeting for 2017, the U.S. Federal Reserve decided to hike its federal funds rate target range by a quarter point to between 1.25 percent and 1.5 percent. It marked the central bank's third rate increase in 2017 and a vote of confidence in an economy that has perked up in recent months. Still, it was just the fifth hike since the recovery from the Great Recession began in 2009.

According to the Taylor rule, an economic theory put forth by economist John Taylor of Stanford University. The rule describes that the nominal interest rate should respond to divergences of actual inflation rates from target inflation rates, and of actual Gross Domestic Product (GDP) from potential GDP. Under these rules, the current theoretical target nominal interest rate would be around 4%, far above the actual Fed funds rate.

In addition, the Fed marginally pushed up its economic growth forecast to 2.5 percent from its 2.1 percent estimate in September, in an apparent nod to the Republican tax-cut stimulus, which means a higher future theoretical rate estimated by the Taylor Rule. So, given the economic conditions, gradual increases in the federal funds rate are highly expected and are expected to prevail in the longer run. This prediction is consistent with the Fed's FOMC statement, "The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate.

The move is likely to ripple across the world economy. 


Source: Bloomberg, Bank of China

The orange line indicates the theoretical target nominal interest rate 

estimated by theTaylor rule; the grey line represents the actual federal funds rate.

Given all this, the question is how should China's central bank optimally respond to the aforementioned long-term hike?

The answers to the question are twofold. First, we analyze whether the exogenous foreign interest rate hike does good to China's welfare, taking China'a macroeconomic situation as given. Second, considering China's own dynamic economic conditions, we propose optimal monetary policy in response to the rate increase. Here, we explore the impacts and optimal corresponding monetary policy based on the Dynamic Stochastic General Equilibrium model developed by Zheng Liu and others, published in the Journal of Monetary Economics. 

Before going into the analysis, we must first acquaint ourselves with China's current economic conditions, especially with its external sector. The act of joining the World Trade Organization (WTO) has brought China an open-trade stance and large and persistent current account surpluses. 

However, China maintains a number of restrictions on its external sector. Its capital account is effectively closed, with tight restrictions on the access of domestic citizens to participate in international asset markets. China also maintains controls over fluctuations in its exchange rates. These restrictions imply that the foreign-currency revenues from exporters have to be purchased by the People's Bank of China (PBOC), China's central bank, at prevailing exchange rates. Given this policy stance, the PBOC's holdings of foreign reserves have grown rapidly and China's monetary policy has become increasingly sensitive to global financial conditions.

There are two ways for the PBOC to finance such purchases, either issuing domestic currency or domestic bonds (called "sterilized"). Obviously, issuing domestic currency will result in an expansion of money supply and a rise in inflation while sterilization won't. But the PBOC might get hurt from sterilization activity because it entails exchanging high-yield (such as 3-month Shanghai Interbank Offered Rate or SHIBOR) domestic debt for low-yield (such as 3-month Treasury rates) foreign assets. Hence, under the prevailing capital account regime, optimal monetary policy in China involves a tradeoff between sterilization costs and price stability.


Faced with this dilemma, the economist Liu and his team suggest liberalizing capital account restrictions and relaxing exchange rate pegs. By liberalizing capital account restrictions, the central bank faces less pressure to absorb foreign capital inflows because domestic citizens can get access to foreign asset markets and thus, the bank would have less need for sterilization. Quantitatively, this reform would reduce the tension between sterilization costs and domestic price stability, leading to superior outcomes for macroeconomic stability and welfare. With a floating exchange rate reform, the central bank could respond to external shocks by adjusting the exchange rate, which would help reduce external imbalances and shield the country from the adverse impact of fluctuations in foreign conditions, even though capital controls remained in place.

When applying the theoretical analysis to the scenario of tghe federal funds rate hike, then, it is not difficult to find that China will get benefits from such rate increases because it reduces the cost of sterilization. Thus, China's central bank could increase the portion of foreign asset purchases financed by selling domestic bonds and reduce the portion financed by issuing domestic currency to avoid excessive inflation. 

But this doesn't mean tge PBOC should keep the monetary policy still and simply enjoy the fruit from exogenous interest rate shocks without looking into itself dynamic development. 

With the stricter regulation of financial institutions and the real estate market in 2017, the hike of interest rates in China outperformed the U.S. markets. The central bank's tightening stance is expected to continue for at least another one to two quarters, meaning China's rate increases will continue and the policy focus this year is curbing property bubbles and cracking down on disorder in financial activities within the banking system, said Chen Long, an economist with Gavekal Dragonomics. The expansion in the interest rate spread between China and the U. S. actually increases the cost of sterilization.

In conclusion, in the present situation, the policy recommendations from Liu and the other economists still hold. In the long run, the optimal monetary policy for the PBOC are (i) partially easing capital controls, which leads to gains in macroeconomic stability, (ii) letting the exchange rate float, which helps restore external balances and enables the central bank to gain more flexibility in addressing domestic price stability, and (iii) doing both simultaneously, which provides the greatest macroeconomic stability gains.