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Is China better at monetary policy than the US?

WChina’s It was a surprise that leaders reappointed Yi Gang as head of the country’s central bank in March.with economics phd Hailing from the US, where he also teaches, Yi Jianlian is the kind of reform-minded, well-traveled technocrat who is disappearing from China’s policymaking establishment.

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His impression as a popular anachronism was reinforced on April 15 when he gave a public lecture in English at the Peterson Institute for International Economics, a think tank in Washington, and then took impromptu questions from the audience. In the conversation, he expressed his respect for market power and economic freedom. “You have to believe that the market correction is largely rational,” he said. As a policymaker, he has pushed for giving households and private businesses “maximum latitude” to buy foreign currency without abandoning capital controls entirely. One of the reasons he takes this position is personal. He remembers that, as a student and professor abroad, he found it difficult to convert yuan into dollars, even for small amounts. “I hate that,” he said.

The Chinese official even half-jokingly argued that his reluctance to intervene in the foreign exchange market was partly due to the fact that traders at hedge funds, securities firms and commercial banks were paid much better and thus probably smarter than he and his hard-working people Central bank team. Asked whether he thought China’s foreign exchange reserves were still safe after the West imposed financial sanctions on Russia, he expressed an almost touching confidence in the “architecture” of the global economy (remember that?).

It was great music to the Washington crowd. But some of Mr Yi’s arguments raised eyebrows. He contrasted the stability of interest rates in China with the activism of the U.S. Federal Reserve. For example, after the covid-19 hit, the Federal Reserve cut interest rates by 1.5 percentage points to near zero. People’s Bank of China (People’s Bank of China) decreased by only 0.2 percentage points. On the contrary, since the beginning of 2022, with the Fed raising interest rates by 4.75 basis points, People’s Bank of China It cut rates by another 0.2 percentage points.

Yi also explained that he was trying to keep real interest rates slightly below China’s “potential” growth rate, the rate at which the economy can grow without increasing inflation. One of the charts he showed showed that since he took office in 2018, real rates have averaged nearly two percentage points below potential rates.

Such guidance raises some thorny questions. Start with the theory behind it. In 1961, Edmund Phelps, who later won a Nobel Prize, articulated the “golden rule” of saving and investing. An economy that obeys this rule will accumulate capital until its marginal product (adding more revenue) equals the economy’s basic growth rate. In this case, the interest rate (closely related to the marginal product of capital) would also fit the bill.

However, this theoretical rule is a rather odd guide to monetary policymaking. After all, central banks do not control the marginal product of capital, they can only exert a very remote influence on it by controlling the rate of investment. Furthermore, why should central banks aim to keep interest rates below potential growth rather than in line with it? In Mr Phelps’ model, interest rates stabilize below the growth rate only when the economy accumulates capital so excessively that its marginal product falls sharply. Such an economy sacrifices consumption for excessive savings and investment, which does not generate any offsetting satisfaction in the future.

Of course, China is often blamed for such overinvestment. So it’s a bit odd to hear a Chinese central bank chief describe one of its symptoms as a policy goal. However, in a speech in Beijing earlier this month, Yi Jianlian made it clear that he was trying to follow the golden rule. In deciding on policy, he targets slightly less than the dazzling growth rate, simply because potential growth is hard to pinpoint (and, presumably, because he would rather undershoot than overshoot).

Uncertainty also explains Yi’s inactivity in rate setting. To justify this approach, he cites the “decay” principle, formalized in 1967 by William Brainard of Yale University, which states that if policymakers are uncertain about the effects of their policies, They should do less than otherwise. In other words, if you are unsure about the potency of a drug, take a smaller dose than you would if you were taking the drug. It sounds reasonable. As one former Fed official once said, “a little central bank dullness is perfectly appropriate”.

But in monetary policymaking, this principle can end up backfiring. As noted in a 2020 paper by Stéphane Dupraz, Sophie Guilloux-Nefussi and Adrian Penalver of Banque de France, smart, well-paid traders in financial markets, and wage and price setters in the wider economy , will begin to anticipate this tedium and adjust their actions accordingly. If inflation gets out of hand, they expect a disincentive response, with the result being a more persistent inflationary misalignment. They may then act on that expectation, setting prices or wages in a way that exacerbates the problem.

Insufficient attenuation

After Yi spoke, Adam Posen of the Peterson Institute noted that other central bankers would be happy to see Chinese policymakers’ inflation record, especially now. China’s inflation rate was just 2% last year. But cautious, restrained policymaking may not be the reason for this unusual price stability. As the country aggressively contained the pandemic in 2020, the central bank didn’t have to cut rates as aggressively as the Fed to save the economy. And thanks to China’s stubborn commitment to a zero-coronavirus policy last year, the central bank doesn’t need to raise interest rates to curb inflation as the Fed did when it was too late. China’s easing monetary policy has succeeded only because of a covid policy that has clearly not eased.

Read more from our economics column Free Exchange:
How the State Controls the Banking System (April 12)
Why Economics Don’t Know Business (April 4)
China now unlikely to be a safe haven (March 30)

Plus: How the Free Exchange column got its name

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