Abstract: The absence of the phrase “no sudden (policy) turns” in a recent statement issued by the People’s Bank of China has sparked speculation over future policy direction. The author argues that the purpose of macroeconomic policy is to counter cyclical fluctuations and the actual policy is determined by the output gap. Currently the output gap in China is more likely to be negative, so it is not yet time to exit from expansionary policies.
On March 24, 2021, the monetary policy committee of People’s Bank of China (PBC) convened its first quarterly meeting for 2021. In the statement issued afterwards, the phrase “no sudden turns”, which had been constantly reiterated by top-level policymakers since the 2020 Central Economic Working Conference, was conspicuously absent, which led market participants to reexamine the country’s macroeconomic policies.
In fact, with the economy getting back on its feet and the pandemic basically under control, it’s essential to go back to the original intention of macroeconomic policies when peering into their future development.
I. Flattening cyclical fluctuations is the most important function of macroeconomic policies
In economics, macroeconomic policies mainly refer to fiscal and monetary policies designed and implemented to flatten out economic fluctuations. Keynesian economics is the theoretical basis for macroeconomic policy-making, providing a concise analytical framework, the IS-LM model, for understanding how monetary and fiscal policies work, when they apply and the expected outcomes.
After the 1929 Great Depression, macroeconomic policies began to prevail in developed countries as tools for dampening economic fluctuations, and achieved good results. But in the 1970s, stagflation occurred in the United States, putting Keynesian economics under challenge, with monetarists and the rational expectations school battering the logic of macroeconomic policies. But the criticisms did not lead policymakers to turn away; instead, they came to develop deeper understanding of operations of the economy while pursuing better deployment of macro policies to counter cyclical fluctuations.
Since the 1980s, developed countries went through the Great Moderation which lasted almost three decades. During this period, low inflation and high growth led policymakers to believe they had tamed economic cycles—until the great financial crisis broke out in 2008. This disaster triggered reflection among scholars, market participants and policymakers upon the weakness in macroeconomic policies, which gave birth to the fundamental concept and regulatory framework of macro-prudential management.
In 2020, the outbreak of COVID-19 dealt a huge blow to the global economy. To avoid irreparable damages, major economies introduced unprecedented stimulus plans that produced immediate effects, stabilizing the financial market after some initial turmoil and providing households with necessary protection. Yet, these came at the price of the biggest surge in government debts since World War II.
What are the long-term implications and potential risks of such colossal government debts? Will the enormous stimulus result in hyper-inflation? Can countries ever exit from the extremely loose monetary policy? Even Larry Summers, an advocate of proactive fiscal policies for years, has expressed concerns over future inflation. Market participants and policymakers are betting over the potential outcome, and the academia is trying to give a more in-depth answer.
Yet, whatever conclusion they reach, it will not be to give up macroeconomic policies or to deviate from the original purpose of flattening out cyclical fluctuations.
Macroeconomic policies can only solve those problems they are able to address. They are not a cure for all, and they will definitely have spillover effects.
The main purpose of macroeconomic policies is to carry out countercyclical adjustment, which means they are targeted at short-term issues by nature. When and how to adjust macro policies are mainly determined by changes in the output gap. This is already fundamental consensus among mainstream macroeconomists.
II. Macroeconomic policies are mainly determined by changes in the output gap
Based on the consensus, let’s take a look at the choice of macroeconomic policies in China.
As discussed above, the direction and intensity of macroeconomic policies are determined by the output gap. Then estimating the output gap or rather the level of potential output becomes the key issue.
There are many ways to estimate the potential output. The simple approach is the HP filtering; and more sophisticated calculation could use structural equations. However, results produced under different approaches could produce hugely different results, which may directly affect assessment of the output gap. For example, the GDP growth rate in Q4, 2020 was 6.5%. If we estimate the potential output growth to be 5-6%, then the output gap is positive, and macro policies need to tighten to guard against inflation.
We could also use other macroeconomic indicators to assess direction of the output gap. Two indicators closely associated with the output gap are the inflation rate and the unemployment rate. If the output gap is significantly positive, then there should be obvious inflation pressure with a sliding unemployment rate, and vice versa. However, current data do NOT point to inflation pressure or lessened strain in the labor market, so the output gap is more likely to be negative.
As of February 2021, the CPI had plunged to the negative territory, in which the base effect played a part. Meanwhile, the core CPI was on a continuous downward ride to a historical low, indicating that China may actually face deflation pressure, rather than inflation pressure.
There has been significant pickup in PPI, but based on historical experience, the transmission from PPI to CPI is unstable and unclear. On the employment side, in December 2020, the surveyed urban unemployment rate returned to the level in the same period in 2019, but rose again in January and February 2021 to 5.5% and 5.4% respectively, higher than in the same period in 2019. This at least means that there remains pressure on the employment market.
Additionally, the latest macroeconomic data suggest the economic recovery in China is slowing down, with uncertainties looming over areas such as export and real estate investments.
First, while production activities remain vigorous, there is a question mark over whether the momentum can be sustained. Excluding the base effect, industrial value added still records a strong year-on-year growth, but the manufacturing PMI has been sliding for three consecutive months which cannot be explained by seasonal factors. That implies that restricted population movement during the Spring Festival did not boost production recovery as expected.
Second, while export continues to serve as a powerful engine for the economy, uncertainties are mounting up. The market in general expects a reversal in China’s export somewhere around the third quarter, because as the vaccination campaign accelerates across developed countries, their supply capacity will receive a boost, and China will no longer enjoy the additional share of global export it had when production activities were bogged down in those countries.
Third, China’s domestic demand lacks sustained momentum given its continued reliance on real estate investment.
Vigorous real estate investments in China have been a strong pillar for the country’s recovery from the pandemic’s blow. But the market does not seem to look to future growth in this area, given the current regulatory stance.
The most anticipated would be boosted investment in manufacturing as a result of improved cash flow from increased exports and the industrial upgrade. However, for China, the peak of industrialization is already in history. Any expansion and pickup in manufacturing investment will be too limited to meet the enormous demand for investment.
III. Sudden turns in macroeconomic policies before Q3, 2021 would be inadvisable
If the above arguments are tenable, then it’s not yet time for macroeconomic policies to change direction, not to mention the speed of the turn.
Recent data suggest a slowdown in China’s recovery, which means that the output gap is closing at a slower pace.
It remains uncertain whether export and real estate investment can sustain their momentum in the next two quarters. Any weakening of domestic consumption or manufacturing investment before they return to normal levels would be a big drag on aggregate demand and economic recovery.
Hence, China should maintain expansionary policies until the recovery is more solid, or the economy may face greater uncertainty. It should wait for at least another quarter to make sure that recovery is sustainable before exiting from the expansionary policies.
To be specific, fiscal policy should focus on improving the efficiency of special bonds and maintaining growth of infrastructure investment while containing the expansion in implicit debts; monetary policy should aim at reinvigorating market players by reducing the interest rate via the price mechanism.
There is no need to release signals of monetary policy tightening or take any action before there is obvious sign of inflation. The PBC could prevent risks through reform measures such as enhancing macro- and micro-prudential management, cracking down on irregularities, improving the efficiency and transparency of the secondary market, etc.
Meanwhile, regulators must fully understand the importance of communication and provide clear signals to guide market expectation. Of particular note, they should avoid giving misleading signals which will add to market uncertainty.
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