PBOC taper now, easing later relative to Fed

Investors are focused on the timing of Federal Reserve liftoff. For China, this raises a question -- how would U.S. tightening affect the People’s Bank of China’s calculus?

This article was written by Bloomberg Economists Chang Shu and David Qu. It first appeared on the Bloomberg Terminal.

The short answer -- not much. Gone are the days when the PBOC followed the Fed in lockstep. A more nuanced answer -- China is leading the monetary tapering now, but could ease relative to the U.S. once the Fed starts to raise rates.

China has shifted its monetary policy stance to a tightening bias and is draining liquidity to temper credit growth -- in contrast to a Fed still on hold.
Our baseline view is that the PBOC has found the sweet spot for interest rates and will stay on hold through 2024.
Once the Fed starts to hike, China’s monetary policy should ease relative to the U.S. -- even if the PBOC hikes or cuts incrementally to calibrate policy according to domestic needs.
Either way, this suggests interest-rate spreads with the U.S. could narrow over the next few years.

China and U.S. policy rates: Scenarios

Doing it my way

The PBOC’s readiness to go separate ways from the Fed, in our view, stems from a willingness to let the exchange rate move more freely. This means the PBOC can place less weight on external conditions, and focus on achieving domestic objectives.

This reflects a new kind of thinking embodied in a phrase that policy makers have increasingly emphasized in recent months, roughly translated as ‘set our own pace.’ This paradigm shift in the policy thinking means divergence in policies in China and the U.S. could become more frequent.

PBOC to follow its own path, not the Fed’s

Projections from the Federal Open Market Committee meeting in June indicated the liftoff in rates could happen as early as 2023. Bloomberg Economics’ U.S. team has moved forward its forecast for rate liftoff to 2023, from 2024-2025, while sticking to its forecast that the Fed will begin reducing its asset purchases early next year.

In the past -- particularly over in 2017-2018 -- when the Fed moved, the PBOC tended to follow suit. We doubt the PBOC will follow the Fed’s next move. In fact, it’s most likely to keep rates steady over the next few years, with a downward bias.

The rapid recovery from the pandemic shock probably peaked in the first half of this year.
A slowdown is probably ahead, as export growth eases, fiscal stimulus is gradually wound down and credit growth moderates.
As the economy returns to a pre-Covid normal, the path for growth will probably be a gradual slowdown -- requiring continued support from monetary policy.

Domestic agenda as the priority (以我为主）

To be sure, China’s policies have already diverged from those in the U.S. in significant ways since the pandemic struck.

China’s fiscal stimulus (3.3% of GDP) and interest rate cuts (30 basis points) pale against the U.S.’s three stimulus packages (23% of GDP), and the Fed’s 150 bps of rate cuts and resumption of asset purchases.
China has started to wind down fiscal support this year, and is tempering the pace of credit expansion.

Fiscal stance – U.S. versus China

On monetary policy, the PBOC’s more relaxed attitude toward the exchange rate is one of the most important factors allowing greater flexibility to set interest rates according to domestic needs.

The PBOC has refrained from directly intervening in the currency market despite considerable appreciation on the yuan since the pandemic began.
China’s growth lead, wider interest-rate differential and accelerated financial opening reduce concerns about capital outflows.
The emphasis today is less on maintaining a yield gap with the U.S. when setting monetary policy and more on making sure the level of interest rates suits domestic needs.
To be sure, the ‘me-centric’ approach does not mean China can ignore global linkages. In fact, it must take them into account.

Two alternative rate paths for China

It’s quite possible the PBOC will adjust rates in response to changing conditions over the two- to three-year forecast horizon.

A sharper-than-expected deceleration could necessitate rate cuts. In this case, the PBOC could lower rates after the Fed starts to wind down policy support, possibly by 10 bps in 1Q 2024 after a potential Fed hike in late 2023.
Should the PBOC judge that financial imbalances are surging due to an overheated economy, it could decide to tighten policy. If so, the PBOC would likely move before the Fed tightens, with possible rate hikes of 10 bps each in 3Q 2022 and 2Q 2023. We attach a relatively small probability to this scenario.

How to detect the PBOC’s path

A range of indicators could shed light on which path the PBOC will take. Our dashboard of data that we think inform its stance is a starting point. Growth indicators are the most critical ones, as our estimation of the Taylor rule for China’s central bank showed. Inflation is also crucial, but is often reflective of growth developments.

The latest indicators point to a need for the PBOC to maintain a tightening tilt (see next page):

Dashboard of indicators gauging PBOC policy stance

China’s recovery has been robust this year but the supply-demand gap has failed to close -- necessitating continued policy support.
A surge in price pressures has been concentrated at factory gates, with little pass-through to still-tame consumer prices. The PBOC expects upstream price pressures to pass as global supply-demand imbalances ease over time.
In our view, the PBOC’s tightening bias will not lead to a hike in interest rates, but instead be expressed in liquidity adjustments aimed at curbing credit expansion.

Impact on currency and yield spreads

The interest-rate differential between the U.S. and China is likely to narrow over the next few years.

At the widest since the pandemic hit the differential between yields on 10-year Chinese government bonds and U.S. Treasuries was around 250 basis points in November.

China-U.S. yield spreads

Expectations of a tighter Fed policy and a stable Chinese policy rate may cause differentials between U.S. and China yields to narrow well before any Fed move.
Against this backdrop, appreciation pressures on the yuan should weaken, though China’s relatively strong growth, and financial opening should remain props over the medium term, even if interest rate differentials become less supportive.

Yuan daily stress indicator