[Authors: William Gao, Alessandro Yang; Advisor: Yingying Daniela Xu]
At the Federal Open Market Committee (FOMC) meeting of September 2024, the Federal Reserve ratio was cut by 50 basis points, which equals half percentage. What exactly is the Fed rate and what implications does it have on the global economy? And what will be China’s response?
The Federal Reserve, also known as the Fed, was created in 1913 to address financial panics, and specifically with the goal of stabilizing the U.S. monetary and banking systems. Its statutory mandate, often referred to as the “dual mandate,” focuses on promoting maximum employment by pursuing high employment levels without triggering inflation, and stabilizing prices by maintaining inflation around a target rate of 2% to ensure economic stability, while also moderating long-term interest rate. The Fed’s structure comprises the Board of Governors, the Federal Open Market Committee (FOMC), 12 regional Federal Reserve Banks, and numerous private member banks. The Board of Governors, located in Washington, D.C., consists of seven members appointed by the President and confirmed by the Senate. The FOMC, which is responsible for setting monetary policy, includes the Board of Governors and five regional bank presidents.
The federal funds rate is the interest rate at which depository institutions lend reserve balances to other depository institutions overnight. The Fed influences this rate through open market operations, primarily by buying or selling government securities to adjust the supply of reserve balances. Other unconventional methods to influence the federal fund rate are discount rate adjustments, where the rate the Fed charges banks for direct borrowing, influencing overall market rates, and forward guidance, which are public statements about future monetary policy to shape market expectations.
While in China, the People’s Bank of China functions as the central banking authority, overseeing monetary policy and the financial system’s stability. Both institutions hold responsibilities in maintaining economic and financial stability in their respective countries. Nonetheless, there are also some key differences.
The Federal Reserve operates independently of the U.S. government, with decisions being made by its Board of Governors and the Federal Open Market Committee. In contrast, the People’s Bank of China is more closely aligned with the Chinese government; being state-owned its policies are heavily influenced by the state directives. This reflects the underlying situation in the Chinese banking system.
The Chinese banking system has undergone a deep evolution path, starting from the 19th Century. The process began with the establishment of the Imperial Bank of China in 1897, modeled on HSBC’s joint-stock firm framework. Later, renamed the Commercial Bank of China following the founding of the Republic of China, it marked a pivotal step toward modern banking. Another key development point was the creation of the Bank of the Board Revenue, the very first Central Bank in China, issuing national currency and serving as a treasury.
Following the establishment of the People’s Republic of China, the banking system was nationalized and centralized under the People’s Bank of China, serving until today as the Central Bank.
The Reform Era brought significant changes as the country embraced market-oriented reforms. The banking sector diversified, leading to the creation of the “Big Four” commercial banks: the Industrial and Commercial Bank of China (ICBC), Bank of China (BOC), China Construction Bank (CCB), and Agricultural Bank of China (ABC). During this period, commercial banking functions were separated from the PBoC, resulting in the establishment of new regulatory and operational frameworks to align with a more market-driven economy.
On the one hand, the American banking system is primarily privately owned, holding decision power over day-to-day operations. Federal institutions do influence monetary policy, however private banks still retain operational independence. On the other hand, China’s banking system is a complex mix of state-owned giants, specialized policy banks, urban and rural institutions, each working in its own field within a framework shaped by government policy and economic priorities.
As previously mentioned, in September 2024, the Federal Reserve made a significant move by cutting the federal funds rate by 50 basis points, lowering the range to 4.75%-5.00%. The long-awaited move was the first rate cut in over four years and marked a shift from the Fed’s recent focus on combating inflation, while controlling the labor market.
One of the immediate effects of a Federal Reserve rate cut is the weakening of the U.S. dollar; as the dollar depreciates, other currencies, including the Chinese yuan, often strengthen in relative terms. However, while a stronger yuan might seem beneficial at first glance, it actually carries several implications, both positive and negative, for China’s economy.
For instance, a stronger yuan can make Chinese goods more expensive for foreign buyers using weaker currencies; this reduced export competitiveness can lead to a decline in demand for Chinese exports, affecting industries that rely heavily on international sales, such as manufacturing, electronics, and textiles; And given that Chinese companies are usually very export-oriented this may lead to lower profits and consequently cost-cutting measures, that include layoffs, this may exacerbate the sluggish consumer spending in China, slowing down the overall economy and making deflation harder to tackle.
On the other hand, by reducing the federal funds rate, the Fed has created an environment that allows China more flexibility to address its economic challenges. In particular, this development offers China an opportunity to combat deflationary pressures, bolster domestic market confidence, reduce capital outflow, ease debt-burden and advance structural reforms by creating policy space maneuver.
This can happen due to preexisting divergent monetary policies between China and the US. In particular, the Federal Reserve has increased its benchmark interest rate ten times since mid-2022, reaching a 20-year high; On the other hand, the People’s Bank of China (PBOC) has been easing monetary policy, lowering its key policy rate – the seven-day reverse repo rate – from 2.1% to 1.7%.
Until recently, the widening interest-rate gap between the U.S. and China constrained the PBOC’s ability to further reduce interest rates as higher U.S. rates were causing the Chinese yuan to depreciate against the U.S. dollar, leading to declining asset prices in China and exacerbating capital outflows. In fact, over the past three years, China experienced capital outflows totaling approximately $787.8 billion, driven by deflationary trends, geopolitical tensions, and slowing population growth.
Given this situation, China seized the opportunity presented by the Federal Reserve’s rate cuts by introducing a comprehensive economic stimulus package aimed at revitalizing its economy. In particular, the People’s Bank of China (PBOC) implemented several monetary policy measures, including reducing banks’ mandatory reserve ratio by 50 basis points and cutting key policy rates and standing lending facility rates by 20 basis points, all to stimulate the housing market by also reducing existing mortgage rates and minimum down payments.
New tools have also been introduced to support financial markets and bolster the stock market. Specifically, a swap facility provided qualified securities, funds, and insurers with access to at least 500 billion yuan to purchase shares. Additionally, up to 300 billion yuan in low-cost PBOC loans became available to commercial banks to fund share purchases and buybacks.
However, while immediate economic stabilization was a priority, China’s leaders were also focused on long-term structural reforms, in particular, the stimulus measures aimed to counter deflationary pressures by boosting demand and encouraging spending. There was also a continued emphasis on transitioning from an export-driven economy to one fueled by domestic consumption and innovation.
In Conclusion, China has several policies it can implement to meet its economic needs in response to the Federal Reserve’s rate cuts, with a strong focus on achieving high-quality growth. Recent efforts include significant investments in advanced and high-tech industries. However, unlike traditional sectors like real estate and infrastructure, these industries may now rely even more on domestic demand due to geopolitical tensions; but due to low internal consumer spending, China might not yet be fully prepared for this shift.
To support these high-tech sectors and sustain growth, increasing domestic consumption is an essential step, and as the IMF has suggested, a stronger focus on boosting consumer spending may help balance economic growth and reduce dependence on external markets.
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