The direction of Chinese monetary policy

The message from China at Davos over the weekend was to "maintain current monetary policy in 2010 and target 8-9% GDP growth". Even more clearly, China will not start its exit strategy until "the rest of the world is ready", said the head of the Bank of China.

This is a very complex statement. Current monetary policy has increased credit much faster than GDP growth. The credit explosion of last year has lead to a real estate bubble. Now the monetary authority has to rein in credit but not too much. They do not want to destroy the growth engine. but they would like to prick the bubble. This is a real world example of what could have happened in the US.

Reserve requirements have been raised slightly. Short term 3-month rates have also been raised. I think the central bank wants to see the reaction to a slight change and then take further adjustments. A gradualist approach makes sense but the lag between policy action and impact on inflation and real growth is unclear. This is very similar to the gradualist approach discussed in monetary policy circles in the 1970's. The objective was to fine tune the interest rate target to control the economy. The results were not pretty. A classic engineering problem between controlling the heat through a weak thermostat.

We will see more tightening in this policy area, albeit slowly. The issue will be the announcement effect on the rest of the world.