24 January 2011 – Chart of the Week

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Chart of the Week: Real Rates in China

Ostensibly, China’s central bank has started raising interest rates to slow the economy and combat rising price pressures. But the two hikes thus far have lagged the doubling of inflation in the last year, leading to a plunge in real rates. Although government officials have shifted to hawkish rhetoric, monetary policy is still about as easy as it gets, at least on this metric.

As US economist Irving Fisher observed over a century ago, the nominal interest rate can be an unreliable gauge of the return on an investment because of the corrosive effects of inflation. A better approach is to split the nominal rate into two parts: the rate of inflation and the real interest rate. For instance, a 10% rate of return can be quite attractive when inflation is low. But if inflation is also running at 10%, then an investor ends up with the same purchasing power as before and has received zero compensation for the risk of the original investment itself.

All else equal, if nominal interest rates go up more slowly than inflation, low real rates could offer an insufficient return to investors and they might choose to spend their cash instead of investing. In that environment, particularly when a central bank has cut nominal interest rates to stimulate the economy, cash is relatively cheap and consumption tends to go up. In contrast, if a central bank raises rates faster than inflation, then high real rates tend to dampen consumption and slow growth, possibly inducing a recession.

By early 2009, in the depths of the global financial crisis, the People’s Bank of China had slashed the one-year lending rate to 5.3%, which is low by Chinese standards. However, a plunge in commodity prices pushed the consumer price index down -1.6% from the year before, the lowest in a decade. As a result of the drop in prices, real rates surged to 6.9%, more than offsetting the central banks’ nominal rate cuts. Rather than central bank easing, it was the massive expansion of fiscal policy that appears to have turned the economy around.

In 2010, inflation roared back and stood at 4.6% in December. Meanwhile, the central bank hiked rates by 25 basis points on October 20 and again on December 24, lifting nominal interest rates to 5.8%. Once again, inflation has more than offset the modest shift in monetary policy and real rates currently hover at just 1.2%.

As before, administrative policy measures are likely to do more of the heavy lifting than monetary policy. Indeed, the government began issuing directives to curtail construction and housing loans a year ago, long before the central bank began to raise nominal rates. More recently, the government started to implement outright price caps, quotas, and other restrictions on the market in order to dampen reported inflation rates.

Milton Friedman taught that inflation is always and everywhere a monetary phenomenon, provided that prices are free to adjust to the forces of supply and demand. In a pure centrally-planned economy, prices are fixed administratively. In China’s mixed economy, where central planning still outranks the free market, monetary policy arguably remains less a tool of macroeconomic policy than an indicator of administrative intent.

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