UBS: Economist Insights: Easing off

While the markets may have been preoccupied with the prospect of a Fed rate rise in September, last week’s decision by the People’s Bank of China (PBOC) to cut interest rates and reserve requirements served to reinforce the divergence that exists amongst the Central Banks. How will that leave the net position for global monetary policy, tighter, easier, or simply no change?

29.10.2015 | 16:31 Uhr

September was all about monetary policy tightening: would the Federal Reserve hike rates? October was all about monetary policy loosening: would the European Central Bank (ECB), Bank of Japan (BOJ) or People’s Bank of China (PBOC) ease policy further? In the end, it was only the PBOC thatdelivered, but the ECB in particular sounded far more dovish than expected.

On the face of it, it looked a bit odd that the PBOC decided to cut rates and reserve requirements in the same week that GDP growth came in stronger than the market expected. Some might interpret this as the PBOC being as doubtful about Chinese growth data as the market. On the other hand, it could reflect pessimism about future growth, or more simply just that inflation remains well below target. Butone other reason that the PBOC has for easing is that looser monetary policy is not really feeding through into looser monetary conditions.

The transmission mechanism of looser monetary policy is to lower real interest rates, increase lending and (often) to push down the exchange rate. But the transmission mechanism does not always work. Despite cutting rates, monetary conditions have not improved all that much (chart 1). The strength of the CNY bears much of the blame for that. Pegging to the USD when it is rising means that China hasbeen running to stand still, with interest rates cuts simply acting to offset the tightening effects of the exchange rate (see Economist Insights, Running to Stand Still, 25 May2015).

This is not the first time that the Chinese transmission mechanism has not worked. Back in 2007, China was hiking interest rates, but this failed to have much impact on lending growth. Following the Financial Crisis, monetary conditions tightened before policy managed to loosen them again.

Now the PBOC must be hoping that eventually the interest rate cuts feed through into looser monetary conditions. Of course, the easiest way to achieve this would be to let the currency depreciate more.

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