First, let us briefly look at China’s currency issuance reform process. On September 24, 2024, the country’s State Council Information Office held an unexpected press conference, where key officials, including People’s Bank of China (PBoC) Governor Pan Gongsheng, National Financial Regulatory Administration (NFRA) Director Li Yunze, and China Securities Regulatory Commission (CSRC) Chair Wu Qing, outlined measures to provide financial support for high-quality economic development. A key announcement from the meeting was the introduction of new monetary policy tools aimed at stabilizing the stock market. Specifically, these measures include creating a swap facility between securities, funds, and insurance companies, which would allow qualified institutions to pledge assets in exchange for direct liquidity from the central bank. This move is designed to direct base money into the capital market, thereby fostering greater stability and growth.
Then a Politburo meeting was held on September 26. The meeting emphasized the need to boost the capital market, guide medium- and long-term funds into the market, and address the blockages in social security, insurance, and wealth management funds entering the market, with the goal of “boosting the capital market”. It also noted that fiscal policy should shift its focus from “stability” to “active” and then to “even more active”. This was accompanied by the expansion and increased issuance of government bonds and a series of stimulus measures for the real estate market. In conclusion, it should be widely agreed that China's monetary policy has significantly shifted, changed direction, and initiated a policy of "loosening" liquidity.
Given that things have already progressed to this point, and the decision to loosen liquidity has been made, the focus has now shifted to risk control. China’s overall debt level was already high to begin with. If we use land sales revenue as a reference, the annual issuance of over RMB 8 trillion in government bonds would be enough to replace local governments' land sales income, yet the actual figure is far higher. The most troubling issue is the hidden debt. Local governments have been accumulating their debt, and this is inevitable, making it unlikely that hidden liabilities will truly be controlled. Once the floodgates are opened, the water inevitably rises, and it becomes impossible to control the scale with the precision suggested by research data. The reality is that macroeconomic issues are inherently complex, making precise control virtually impossible. The key is to set certain "red lines" and, when necessary, apply the brakes to prevent things from spiraling out of control. This way, with the right "windows", "tools", and "means", it is possible to stabilize the broader macroeconomic situation.
Looking at the current situation, the PBoC's main focus in its regulatory work remains on opening up the interest rate channel. Through reform and adjustment, it seeks to enable interest rates to play a better leverage role. This approach to monetary policy is correct, but it is still in its early stages. From the central bank's perspective, the more important issue is risk control, which not only concerns the present but also the future and market expectations. The key measure to achieve effective risk control is to establish an observable and objective risk alert line. My suggestion is that inflation should be set as a fixed target and become the red line for China's monetary policy.
Frankly speaking, the control standard for this inflation indicator is crucial and has actually gone beyond the PBoC's authority. It may even be necessary for the central government to make the final decision. Based on available data, considering government bond issuance and future issuance capacity, setting the inflation target at 1.5% for 2025–2026 would be appropriate. This would leave ample room for monetary issuance while keeping inflation within an acceptable range for society. It could even allow for moderate interest rate cuts, providing the central bank with more flexibility in its monetary operations. If further regulatory space in the future is included in the considerations, the upper limit for inflation could be set at 3%. If inflation exceeds this level, it would signal significant risk, as the inertia of price levels might push inflation toward the 5% threshold.
The purpose of these empirical analyses is for the PBoC to establish a mechanism that closely monitors the inflation target to control risks, while also supporting the implementation of a more proactive fiscal policy. In fact, the central bank has always paid close attention to inflation indicators. However, this has not been part of a comprehensive monetary policy framework but rather a policy focus within temporary adjustments. Under the condition of a more proactive approach, it will be necessary to establish a more quantitative monetary policy system to control risks and prevent the situation from escalating to a more serious state. Therefore, creating a monetary decision-making mechanism that closely tracks the inflation target is crucial. This would fundamentally change the current situation, where policies are often determined through assumptions. Instead, such a better approach can make China’s capital markets more objective, more quantitative, and transparent. This will help reduce unnecessary market volatility, which is not desirable for policymakers.
In China, there are quite a few professionals in the financial sector and capital markets who specialize in risk analysis. They are all well aware that when the central government decides to loosen liquidity and adopt a more proactive policy. This requires the construction and design of supporting mechanisms for monetary policy. The most important of these is the setting of an “inflation control line” to manage macroeconomic risks. This is akin to establishing a circuit breaker for social risks. Once the situation reaches a certain point, corresponding measures must be taken; otherwise, chaos will ensue. This creates a clear market consensus, giving China's monetary policy greater market credibility.
From the perspective of potential negative policy effects, it is probable that the implementation of more proactive fiscal policies could lead to a scenario where many subsequent actions would take place. When considering the replacement of land sales revenue, the original target of RMB 8 trillion per year should be sufficient, yet it continues to increase. This assessment is based on a one-year time frame, and it seems likely that further increases will occur. If this cycle persists without a risk control mechanism to secure the already opened floodgates, there is a significant risk of a major crisis.
From a trend analysis perspective, several years ago, the first policy research institution to seriously discuss the idea of “loosening liquidity” was ANBOUND. However, we are now concerned about the consequences of this “loosening liquidity”. The negative effects, from the perspective of the macro-market environment, mainly involve two issues: one is exchange rate fluctuations, and the other is inflation. The former pertains to external circulation, with the potential consequence being a depreciation of the Chinese currency. The latter is related to internal circulation and directly affects social stability. Therefore, it is riskier, more important, and has a more direct impact.
Although at times I criticized the Federal Reserve, I must admit that many of the Fed's experiences are extremely valuable and worth serious study by policymakers. The Fed sets a "2% inflation rate" as its control line. Once this inflation target is exceeded, it becomes necessary to refrain from printing large amounts of money and instead raise interest rates to cool down the economy and bear the consequences. On the other hand, if inflation is below the target, it allows for the issuance of more currency and the possibility of lowering interest rates to heat up the economy. This set of "weather forecast-like" monetary policy principles, once established and properly applied, can greatly reduce the risk of uncontrolled financial instability in China.
It should be pointed out that the Federal Reserve's "2% inflation target" is also purely based on experience, with little "scientific" rationale behind it. The main considerations and concerns are the social effects. As mentioned by Fed senior economist J. Charles Partee in a March 1973 discussion of the Federal Open Market Committee, due to "strong social and political pressure", this explanation was later frequently used by the Fed. The 2% inflation target was officially adopted by the Fed in 2012, but in reality, the Fed and central banks of other countries had informally used this inflation target during the high inflation periods of the 1970s and 1980s.
Of course, the Fed considers a 2% inflation rate to be ideal, but how did the central bank leaders of various countries determine that 2% was the "ideal inflation target", and not some other figures? This has been a question raised by critics of the Fed. Bank of America, for instance, has commented on this issue, with officials from the largest U.S. bank stating bluntly that the 2% inflation target is “nothing special”. In fact, the Fed is not the only central bank to set a 2% inflation target; many other countries have adopted the same goal, which seems to further confirm that the 2% target is relatively ideal and a benchmark worth following.
Overall, it is feasible for the PBoC to set the inflation target at 1.5% and the potential inflation target at 3%, using these as the basis for monetary policy regulation. This will help to ensure the stability of the capital market, move away from China's current deflationary and de-inventory situation, and also contribute to reducing the market risk exposure of the banking system despite high levels of debt. Once inflation rises significantly, banks' large amounts of receivables could be effectively wiped out, and the consequences of this are difficult to imagine. In conclusion, the immediate priority should be to establish an inflation red line, and the quicker this can be done, the better.
Final analysis conclusion:
China's current monetary policy has shifted direction and entered the "loosening liquidity" phase, bringing with it inflation and debt risks that cannot be ignored. To effectively control these risks, it is essential to establish an inflation control red line as soon as possible, setting the short-term target at 1.5% and the potential upper limit at 3%, thereby providing clear boundaries and flexible space for monetary policy operations. This mechanism will act as a "social risk circuit breaker", ensuring that under the context of a "more proactive" policy, the market forms clear expectations and preventing the macroeconomy from running out of control. Dynamically monitoring inflation indicators will not only provide the central bank with maneuvering room for monetary operations but also effectively reduce the risk exposure of the banking system. Therefore, the establishment of an inflation red line is not only a necessary step in current risk control but also an important reform direction for achieving long-term macroeconomic stability and policy transparency.
