China: PBoC interest rate cut suggests more focus on inflation target

The People’s Bank of China (PBoC) Saturday cut both its 1-year lending rate and 1-year deposit rate by 25bp to 5.35% and 2.50% respectively. Interestingly the PBoC’s main argument for cutting interest rates was concern about the recent decline in inflation and possible risk of deflation.

So far macroeconomic policy in China has been guided broadly by a floor for GDP growth (7.5% in 2014) and a ceiling for inflation (3.5% in 2014). However, it has been unclear to what degree there is a lower bound for the inflation acceptable for the Chinese government and how low a possible lower bound is. CPI inflation in January declined to 0.8% y/y from 1.5% y/y in December driven in our view mainly by distortions from the timing of the Chinese New Year public holiday. We expect inflation to rebound to close to 2% y/y in February before normalizing around 1.5% y/y in March.

The Chinese government will announce the main macroeconomic targets for 2015 in connection with the National People’s Congress (NPC) that convenes on 5 March, later this week. It will be a major surprise if the target for GDP growth is not cut to 7.0% in 2015 from 7.5% in 2014. There is also ample room to cut the inflation target from 3.5% in 2015, albeit at this stage it is more important to signal a lower bound for inflation or a more explicit inflation target.

China’s manufacturing PMIs were overall better than expected in February. The official manufacturing PMI in February improved to 49.9 (Cons: 49.7, DBM: 50.0) and the HSBC/Markit manufacturing PMI in its final reading improved to 50.7 (revised up from 50.1) from a final reading of 49.7 in January. The substantial upward revision of the HSBC/Markit manufacturing PMI suggests that late responders have been more positive. While the manufacturing PMIs suggest that the Chinese economy remains relatively subdued, there are tentative signs of stabilisation. It is also worth noting that the manufacturing PMIs are not yet at levels that are usually associated with aggressive easing from the PBoC.

With the PBoC currently having a clear easing bias in monetary policy there is also increasing speculation in the market that the PBoC will target a weaker CNY to support growth and ease deflationary pressure. The PBoC this morning raised the reference exchange rate for USD/CNY (used to fix the daily trading band) by 0.06%. That said, in the big picture it is too early to conclude that PBoC is targeting a weaker CNY (see chart below). At the moment USD/CNY is trading at is ceiling in the daily trading band and the PBoC is intervening in the FX market to keep USD/CNY within the daily trading band. This is draining liquidity in the interbank market and hence in isolation working against the PBoC’s intention of lower interest rates.