Abstract: Lowering policy interest rates has been considered a standard prescription for weak demand and low prices, but it consistently faces skepticism, mainly for the following five reasons: 1) Doubts about whether the reduction in short-term policy interest rates can be transmitted to a decrease in lending rate; 2) Uncertainty about whether the rate decrease can stimulate credit growth and boost overall demand; 3) Concerns that excessively low rates could squeeze bank profits and harm financial stability; 4) Worries about causing speculation and price bubbles in the bond market; 5) Apprehension that lowering rates might lead to depreciation pressure on the Chinese yuan. In this article, Zhang Bin provides a detailed analysis of these doubts.
There is a high degree of consensus in the international academic community on the prescription for insufficient demand and low prices: lowering policy interest rates and, if that is not enough, quantitative easing; keeping financial intermediation functioning; and, if the first two are not enough, increasing public spending stimulus.
From the experience, no matter what the initial cause of the shortage of demand or the degree of the shortage of demand, if the first two points can be achieved with the real interest rate fully going down, demand will be sufficiently boosted, and credit, demand, jobs, and investor confidence will slowly pick up.
This is not a rare prescription. But the consensus among academics and policymakers comes at a price. Historically, it has been hard for monetary authorities to make up their minds about how interest rate policy can alter aggregate demand. Without the painful lessons of the Great Depression, decades of research by macroeconomic academics, and the experience of the United States, the Euro Zone, and Japan in relying on easy monetary policy to counter deficient demand, it would have been hard to come up with this highly agreed-upon prescription.
The Great Depression of the 1930s was a catastrophe. Friedman argued that the death of Benjamin Strong in 1928, the New York Fed Chairman, left a power and perception vacuum. Between 1929 and 1931, the Fed's response to the downturn was much weaker than the recessions of 1924 and 1927.
To protect the gold standard, the Fed began raising interest rates sharply in October 1931, leading to deepened bank failures and the economic downturn and worsening the Great Depression. In Keynes' words, the Great Depression is amazingly stupid. Friedman's claim that monetary policy caused the Depression was further corroborated by the later research on the gold standard. ‘Regarding the Great Depression, … We did it. We’re very sorry. … We won’t do it again,’ said Ben Bernanke in a speech at ‘A Conference to Honor Milton Friedman … On the Occasion of His 90th Birthday.’
The Fed's blunder during the Great Depression was largely due to its belief in the gold standard and the “Real bill theory” that prevailed. The Fed used the volume of discounted loans made by commercial banks and changes in market interest rates as policy indicators. When the volume of discount loans by commercial banks and market interest rates fall, , the Fed sees this as an easing of the monetary policy environment. Conversely, when the volume of discount loans by commercial banks falls and market interest rates rise, it is seen as tightening monetary conditions. The Fed has no way of getting commercial banks to increase credit.
After the crisis of 1929-1931, when commercial banks' discount loans fell sharply and market interest rates fell, policymakers decided that the monetary environment had become so loose that there was little further that the monetary authorities could do, they should wait for the economy to recover, and the result was a very inadequate response from the Federal Reserve. In 1931, to protect the gold standard, the Fed raised interest rates sharply, causing wider bank failures and deeper depressions.
Japan plunged into deflation in the late 1990s. The Bank of Japan quickly cut its policy rate to zero but raised it again before it was out of deflation. In 1998, Krugman caused an uproar in Japan when he wrote that deflation was essentially a monetary phenomenon and that the solution lay in monetary policy; even if the policy interest rate fell to zero, monetary authorities could still get out of deflation by introducing inflation targeting and quantitative easing. Bernanke, Blanchard, Takatoshi Ito, Frederic Mishkin, Hiroichi Hamada, and other well-known economists have also advised Japan to do so. But the Japanese government and the BOJ were sceptical about the role of further monetary easing.
In 2001 Aso Taro, then Japan's economy minister, said it was not advisable to consider only monetary policy and that no country in the world had adopted inflation targeting in order to turn deflation into inflation.
In 2002, then-governor of the BOJ, Tsuyoshi Ishiguro, said, “I think I'm a deflation fighter, and inflation targeting can't raise prices at a time when interest rates are at zero, and there are bad claims. Inflation targeting is a blind bet on the government and the Bank of Japan and will only reduce confidence in both.”
The governor expressed two concerns about loose monetary policy: whether it would improve the real sector of the economy and whether it would have an adverse impact on long-term interest rates. The Japanese authorities dithered until 2013 when the Abe government came to power and largely adopted Krugman's recommendations, after which the Japanese stock market, credit, and inflation entered positive territory, and the economy emerged from deflation and the “Lost two decades”.
After the sub-prime mortgage crisis in 2008 and the European debt crisis in 2011, the United States and the euro area are also facing serious insufficient demand pressure. With the classic cases of the Great Depression and Japan and decades of academic research, the United States and the Euro Zone responded early and aggressively to inadequate demand and low inflation, and policy interest rates quickly fell to zero, combined with quantitative easing. Both the US and the Eurozone avoided severe demand shortfalls and deflation even in the face of severe market turmoil.
China's core CPI fell below 1 for three consecutive years between 2020 and 2022. In the first half of 2023, both core CPI and CPI grew by 0.7% year-on-year, while PPI grew by -4.1% year-on-year. The main reason for the low prices was insufficient demand. There is widespread scepticism in the research community about reducing policy interest rates substantially - the standard prescription of the international academic community on how to get out of the problem of insufficient demand and low prices.
The doubts mainly are: 1) whether a fall in short-term policy interest rates can be passed on to lower lending rates; 2) whether lower interest rates can boost credit growth and demand; 3) overly low interest rates squeeze banks' profits and are not conducive to financial stability; 4) overly low short-term policy interest rates cause speculation in the bond market and bond price bubbles; 5) lower interest rates bring downward pressure on the RMB. I will answer these questions one by one.
Before responding to these questions, it would be useful to outline the mechanisms through which the reduction of policy interest rates affects aggregate demand.
The conventional wisdom is that lower interest rates stimulate an increase in credit and investment, which in turn leads to an increase in aggregate demand. The modern view is that lower interest rates affect consumption, investment, government spending, and net exports through multiple channels. For household spending, lower interest rates lower the cost of debt for indebted households, raise valuations of assumed equity and real estate holdings, strengthen household sector balance sheets and support consumption; Lower interest rates also support consumption by changing the intertemporal price of consumption.
For corporate spending, lower interest rates not only reduce the cost of debt financing, but also increase asset valuations, improve access to financing, increase risk appetite and support investment through multiple channels. For government spending, lower interest rates lower the cost of government debt, allowing the government to spend more while maintaining the same deficit rate. For exports, lower interest rates lead to a certain devaluation, which can boost exports and raise domestic prices, a mechanism that has served Japan well in its experience of coming out of deflation.
For a complete description of the above-mentioned mechanisms and a simple quantitative analysis that takes into account China’s situation, see the author's CF40 working paper, The Role and Side Effects of Monetary Policy, co-authored with Zhu He, Research Fellow at CF40 Institute. As China's debt, equity, and real estate markets have expanded dramatically, the impact of interest rates on economic performance has increased substantially.
I. WILL THE DECREASE IN THE SHORT-TERM POLICY RATE LEAD TO A DROP IN THE LENDING RATE?
The short-term policy rate is the central bank's 7-day reverse repo rate, which stands for the short-term interest rate at which the central bank lends to commercial financial institutions. The rate affects the short-term cost of funding for commercial financial institutions, which will in turn be transmitted to other different types of interest rates as well. As an analogy, if the policy rate is reduced to zero, eligible commercial financial institutions can obtain financing from the central bank at zero cost, and commercial financial institutions will thus reduce their lending rates and deposit rates. Based on our experience, this transmission channel is also smooth. The last time the central bank significantly reduced the short-term policy rate was in 2015. From the beginning of 2015 to the end of 2015, the policy rate represented by the 7-day reverse repo rate fell by 185 basis points, the weighted average interest rate on RMB loans to financial institutions fell by 193 basis points, and the weighted interbank pledged repo rate fell by 288 basis points. This indicates a smooth transmission mechanism from the short-term policy rate to medium- and long-term lending rates.
II. WILL LOWER INTEREST RATES BOOST CREDIT EXPANSION AND AGGREGATE DEMAND?
The transmission of lower policy rates into the decline of lending rates will have divergent impacts on different borrowers, but the overall financing condition will improve significantly. For household mortgage loans, the large cut in lending rates means a sharp decline in monthly debt service, which will reduce the threshold for households to buy property. For manufacturing enterprises, platform companies, and real estate companies, lower lending rates will not only reduce financing costs but also enhance the cash flow, asset valuation, and thus their financing conditions. This is especially important for real estate enterprises and platform companies that currently experience liquidity strain.
Lower interest rates affect aggregate demand through many channels, one of which is by stimulating demand for credit. Our simplified calculations based on historical data found that a 100 basis point decline in the policy rate could save households, businesses, and the government $774 billion, $1,259.9 billion, and $159.7 billion RMB in interest payments, respectively, and generate net cash flow increases of $118.8 billion, $944.2 billion and $124.8 billion RMB to the three sectors, respectively. And that's just one channel to reduce the interest cost of debt; the improvement in the balance sheets of households, businesses, and the government are even more significant when the boosts to real estate and stock market values are taken into account. This would not only directly improve spending but also be a huge support for enhancing lending capacity and accessibility.
Some scholars are in favor of stimulating the economy through increased fiscal spending and public investment, which would indeed also serve to increase aggregate demand and bring the economy out of the downturn. In the current economic environment, either a substantial cut in the policy rate or an increase in public sector spending will help boost the economy. If we compare the two methods, one is to increase public spending directly, and the other is to improve the financing conditions and financing capacity of market entities so that the market can increase spending spontaneously. The distortion brought about by the latter may be smaller. In addition, lower interest rates create better supportive conditions for increasing government debt and spending.
III. WILL ULTRA-LOW INTEREST RATES SQUEEZE THE PROFITABILITY OF BANKS AND THREATEN FINANCIAL STABILITY?
Based on experience, after the policy rate is reduced, the decline in lending rates will exceed the decline in deposit rates, and the spread between banks' deposits and loans narrows, thereby cutting banks' profits. However, if the economy can not move out of the downturn, the demand for credit will continue to decline, and the bank's profitability is also not guaranteed. If the skin is gone, how will the hair be attached to it? For the stability of banks or the stability of the entire financial sector, the decline in bank profits is only one aspect. Another aspect is that after the society’s average interest rate falls, the bank's bad debt ratio will fall sharply, and the bank's asset quality will rise sharply. This is even more important for the sound operation of banks and other financial institutions. An important rationale for Japan's sharp reduction in the policy rate after the 1998 banking crisis was to help reduce non-performing loans. If we only focus on banking sector profitability and the closely related bonuses for bank employees, lowering interest rates can be costly in the short run. But if we focus on bad debt ratio and the quality of financial assets, lower interest rates are more of a boon and a safeguard.
IV. WILL ULTRA-LOW POLICY RATE LEAD TO SPECULATIONS IN THE BOND MARKET AND PRICE BUBBLES?
When economic fundamentals are weak, financing demand is low, and the market expects the policy rate to be adjusted downward, if the monetary authority makes no adjustment or an adjustment well below what the market expects, this will incentivize investors to speculate on future downward adjustments in interest rates. When the economic fundamentals are weak, the financing demand is low, and the market expects the policy rate to be adjusted downward if the monetary authority makes an adjustment in line with market expectations, some investors may increase leverage and duration in order to increase the profitability but at the same time also bear a greater risk. In comparison, maintaining a policy rate adjustment consistent with economic fundamentals is more helpful in curbing speculation. It is necessary to pay close attention to the leveraging behavior of financial investors in a low-interest-rate environment, but using this as a reason to oppose lower interest rates is like giving up eating for fear of choking. Rather than sacrificing monetary policy tools, financial regulatory measures would be a more appropriate way to deal with leveraging behavior and financial risks.
V. WILL LOWER INTEREST RATES ADD PRESSURE ON RMB DEVALUATION?
Based on experience, this is not necessarily the case. The China-US interest rate spread is one factor that affects the exchange rate and capital flows, but a more important factor is the domestic economic fundamentals. The impact of the China-US interest rate spread on the exchange rate is not that large, and the experience of the past few years has fully illustrated this point, with the China-US interest rate spread turning from positive to negative and the RMB exchange rate not depreciating greatly. By lowering interest rates to improve domestic economic fundamentals, the RMB may not weaken. Even if lower interest rates weaken the RMB (either a small depreciation or a large depreciation), a moderate depreciation is in fact good for boosting exports and aggregate demand. Therefore, it is not necessarily a bad thing. From Japan's experience, currency depreciation brought about by low interest rates is one of the important channels for expanding demand and overcoming deflation. Will there be a sharp devaluation? As China is a country with a huge trade surplus, it does not have too much inflationary pressure. If the RMB faces huge depreciation pressure, it will never be due to interest rate spread but more likely to be the impact of serious problems in China's economic fundamentals or changes in geopolitical relations. Lowering interest rates to improve economic fundamentals is precisely the way to protect the exchange rate instead of putting pressure on it.
This article was first published in CF40’s WeChat blog on August 4, 2023. It is translated by CF40 and has not been reviewed by the author. The views expressed herewith are the author’s own and do not represent those of CF40 or other organizations.
