China Money Supply Moves Growth More Than Rates in Fed Research

  • Economists in U.S., China write in paper published by NBER
  • Report: ‘Changes in M2 growth have considerably larger impact’

Changes to China’s broad money supply have more of an impact on growth than interest rates, according to new forecasting models developed by Federal Reserve researchers.

Such a finding is contrary to the conventional wisdom about the importance of interest rates, which are more applicable to the U.S. and other developed economies, according to a working paper this month by Patrick Higgins and Tao Zha of the Atlanta Fed and Karen Zhong of Shanghai Jiaotong University.

The modeling has implications for policy because China is shifting from a tightly regulated system where the central bank set policy with quantitative outcomes in mind -- such as the amount of new loans extended each month -- to one where liquidity is determined by the price of capital. The research suggests that may not be appropriate for the economy. 

“Contrary to the common belief based from the robust studies on the U.S. and other developed economies, we find that the impact of interest rates on the aggregate economy is relatively muted while changes in M2 growth have considerably larger impact,” the economists wrote in a working paper, referring to the broad measure of money supply. “Macroeconomic analysis of China should be based on these facts, not on off-the-self models working for other economies.”

The analysis suggests China’s economy will have a gradual slowing, not a growth rebound, the researchers wrote. Their model signals that the most likely path of gross domestic product growth will be an expansion that hovers around 6.5 percent for the next five years while consumer prices are predicted to rise 1.9 percent this year and 1.7 percent for the next four. That’s below the 3 percent pace policy makers target.

Target Pace

The world’s second-largest economy grew 6.9 percent last year, the slowest since 1990. It will decelerate to 6.5 percent this year, the government’s minimum target pace, then slow to 6.3 percent in 2017 and 2018, according to economists surveyed by Bloomberg.

China’s M2 gauge has been rising less than the narrower M1 gauge. M1, which includes currency in circulation and bank deposits, surged 24.6 percent in June from a year earlier, most in six years. The broader M2, which also includes savings deposits, gained 11.8 percent. That rate was unchanged from May and below the government’s 13 percent annual target.

Changes in the pace of M2 expansion exert “considerable impact” on Chinese economic growth, according to the researchers. “A slowdown in M2 growth would be a sensible policy scenario to consider because it allows time for China to adjust from an investment-driven economy to an economy more oriented to services and consumption,” they wrote.

The researchers said future economic growth will be more of an “L-shape rather than U-shape,” using terms from the Communist Party’s People’s Daily interview in May with an unnamed “authoritative person.” The person who said future growth isn’t due to rebound and China must face up to its bad loans and other risks associated with soaring debt. 

The economists also cited opposing voices calling for more of a a U-shaped growth rebound such as Professor Li Daokui at Tsinghua University in Beijing and a former academic adviser to the People’s Bank of China, as well as comments in April by Sheng Laiyun, a spokesman for the National Bureau of Statistics.

The working paper was published by the National Bureau of Economic Research in Cambridge, Massachusetts. Higgins is an associate policy adviser in the Atlanta Fed research department who builds forecasting models and helped develop the reserve bank’s GDPNow forecast model. Zha is executive director of the reserve bank’s Center for Quantitative Economic Research and an Emory University economics professor. Zhong is at Jiaotong’s Shanghai Advanced Institute of Finance.