This morning the People’s Bank of China (PBoC) cut its key policy rate by 25bp to 5.1% – undoubtedly reacting to worries about slowing growth. The question is whether such a cut is warranted or not?
I have long argued that over the long run 15% M1 growth has been consistent with nominal stability in China. Hence, from around 2000 to 2008 Chinese M1 stayed on a pretty narrow path around 15% yearly growth. In the PBoC reacted to the global shock and the expected negative shock to Chinese money-velocity by expanding money supply growth significantly pushing M1 way above the 15% trend – probably overdoing it quite a bit (and luckily so for the global economy)
However, since mid-2010 actual M1 has started to re-approach the old 15% trend and in 2014 actual M1 dropped below the 15% trend – indicating a tightening of monetary conditions. The graph below illustrates that.
Obviously one could easily argue that 15% M1 growth might be too excessive today as Chinese real GDP trend growth has slowed in recent years and will slow further in the coming years.
I would certainly agree with such argument. Therefore, I have tried to look at an alternative M1 trend where I assume the M1 growth should slow in line with a slowdown in potential real GDP growth from 10% (around 2010) to 6% in 2020. This basically means that I assume a gradual slowdown in “trend” M1 growth from 15% in 2010 to 11% in 2020.
The graph above also shows that (the green line). This trend (“Slowing trend growth”) is also still above the actual M1 level, but not by much. So in that sense today’s rate cut can be justified, but on the other hand based on such simple measures of the ‘money gap’ it is hard to argue for major monetary easing.
So what did I miss? Well, money-velocity. The calculations above assumes a stable trend in M1-velocity over time. That is probably wrong to do – particularly because the Chinese authorities are planing further financial sector liberalisation. But I will have to write about that at another time – now it is time to take the kids to the playground…