He Xiaobei: low inflation indicates need for further accommodative monetary policy

PKU economist argues China’s monetary policy has room but suffers from excessive objectives, suggesting a shift to household debt relief to unlock consumer cash instead of merely boosting loan growth.

Recent data show that China’s CPI have fallen into negative territory for two consecutive months (Mar and April 2025), indicating a growing risk of deflation. However, some economists argue that further monetary easing in China would be “pushing on a string,” unable to encourage borrowers to take on more credit even as growth slows. He Xiaobei, Research Fellow at the National School of Development (NSD) at Peking University, disagrees. Low inflation, she argues, is not evidence of failed monetary policy; instead, it indicates that accommodative monetary policy has not yet gone far enough. Her evidence: since 2022, corporate financing costs are now considerably higher relative to historical norms, and money supply growth remains modest by world standards.

While critics warn that deeper easing would simply stuff more cash into ineffective SOEs and industries awash with excess capacity, He argues that overcapacity is mostly confined to certain sectors, too small to dictate nationwide prices. And while banks struggle to create new credit, a sharp reduction in mortgage rates could still free up as much as 800 billion yuan in household cash—money that might flow into consumption. In short, she argues, the People’s Bank of China should shift away from quantitative loan targets, reduce rates for heavily indebted households, and utilise macro prudential tools for financial stability.

He has kindly reviewed and proofread the translation of her article, originally published by the NetEase Research Institute, a think tank focused on China’s financial and economic policy, on March 7. It is also available on the official website of the NSD.

何晓贝：对低通胀下货币政策的再思考

He Xiaobei: Rethinking Monetary Policy under Low Inflation

Since last September, China’s macroeconomic policy stance has undergone a clear shift, and the People’s Bank of China (PBOC) also announced that its monetary policy stance would move from “prudent” to “moderately loose.” Nevertheless, policymakers seem to remain cautious about how to proceed with further monetary easing.

On one hand, some believe that monetary policy is already highly accommodative but has failed to boost inflation, implying that further easing would yield limited results. Some experts even warn that additional loosening could lead to more capital flowing into overcapacity industries, thereby worsening deflationary pressures. On the other hand, some argue that further easing faces practical constraints, as banks are already finding it difficult to expand lending, making monetary policy like “pushing on a string.”

In fact, the fact that inflation hovers around zero does not mean monetary policy has failed; rather, it indicates that accommodative monetary policy has not yet gone far enough. At present, numerous factors are constraining the effectiveness of monetary policy. It is therefore both urgent and essential to establish a clear aggregate target and to move beyond the traditional quantity-based operational framework.

1. Has China’s Monetary Policy Become Ineffective?

In recent years, growth in the broad money supply (M2) has significantly outstripped GDP growth, and loan interest rates have dropped sharply. Yet inflation has remained subdued. Some experts take this as a sign that China’s monetary policy is losing its effectiveness and that further easing would have little impact. In fact, the current monetary policy stance, either measured by interest rates or monetary aggregates, is not sufficiently easing.

Firstly, real funding costs in the corporate sector have risen significantly over the past few years. China’s weighted average interest rates on loans (adjusted for inflation) minus real GDP growth—commonly referred to as r–g—stood at around –3% to –4% between 2012 and 2020, but has risen by nearly 3 percentage points to approximately –1% since 2022. While the low interest-growth differentials in the past resulted from intended financial repression, the sharp rise in the differentials after the pandemic indicates that corporate financing costs are now considerably higher relative to historical norms.

International experience shows a contrasting pattern: in the decade before the COVID-19 pandemic, Japan’s average r–g , measured by differentials between real loan rates and real GDP growth, hovered around –1%, but fell by 3 percentage points to as low as –4% in the aftermath. In the United States, r–g, measured by the differentials between real corporate bond yields and real GDP growth, also declined by roughly 3 percentage points following the pandemic. Both countries experienced a marked acceleration in inflation after 2022.

Second, monetary aggregates tell a similar story. Chinese policymakers have traditionally emphasised the growth of the broad money supply, as the implementation of monetary policy still largely relies on quantitative tools, such as credit growth targets for commercial banks. However, the relationship between money supply and inflation is quite complex. Numerous studies (Borio et al., 2023; Cadamuro and Papadia, 2021; Gertler and Hofmann, 2018, etc.) show that the relationship between inflation and money growth depends on two different regimes: the moderate-inflation regime and the high-inflation regime. When inflation is moderate or low (below 6–8%), there is no clear correlation between money growth and inflation. A strong relationship tends to emerge only when inflation is exceptionally high (above 6–8%).

Specifically, in a moderate inflation environment, inflation is largely influenced by sector-specific factors (such as pork or energy prices) and shows little to no correlation with aggregate monetary growth. For more than two decades, from the 1980s until the 2008 financial crisis (an era known as the “Great Moderation,” during which inflation remained low across major economies), inflation became detached from money supply dynamics. Against this backdrop, many central banks reformed their monetary policy frameworks, abandoning money growth as a key reference indicator.

In contrast, in a high-inflation environment (with inflation above 6–8%), the situation is different: “excessive” growth in the money supply is strongly associated with high inflation. For example, before the pandemic, the U.S. M2 grew about 5% annually, but in 2020, it grew by over 20%. The Eurozone’s M3 grew around 5% annually pre-pandemic, and over 10% in 2020. The UK, Canada, Brazil, and Thailand saw similar patterns—in 2020, their money growth at least doubled relative to pre-pandemic levels. All of these countries and regions experienced high inflation after the pandemic.

In comparison, China’s monetary expansion in the post-pandemic period has been quite limited. After COVID, China’s M2 year-on-year growth peaked at about 12%. Though this exceeded the pre-pandemic average of 8–9%, it represented only a moderate increase and fell far short of the “excessive” money growth observed in the aforementioned economies (indeed, in 2024, China’s M2 growth rate had fallen below the pre-pandemic average). Data on total social financing and bank loans even show a steady decline after the pandemic, from approximately 13% to under 8% at present.

The above evidence clearly shows that China’s monetary expansion is not yet at the level that would trigger high inflation. In other words, it is not that the accommodative monetary policy has failed—it simply has not been sufficiently accommodative.

2. Would Accommodative Monetary Policy Cause Deflation?

Policymakers are concerned that further monetary easing could lead to more capital flowing into inefficient state-owned enterprises (SOEs) and overcapacity industries, potentially exacerbating structural imbalances. Some economists argue that, due to structural imbalances between investment and consumption in China’s economy, an accommodative monetary policy would mainly increase credit to the production sector, with only a small share flowing to the household sector—thus deepening overcapacity, suppressing consumption, and intensifying deflationary pressure. However, this view does not hold up under scrutiny.

First, overcapacity and soft budget constraints are confined to only a few sectors. For a long time, local governments and their financing vehicles have been the main entities with soft budget constraints. However, under mounting pressure to reduce debt, these local governments have exacerbated the economic downturn. Among traditional industries with overcapacity, the most prominent is steel, yet steel-related prices account for only 6% of the Producer Price Index (PPI) and contribute even less to the Consumer Price Index (CPI), rendering them insufficient to generate broad-based deflation. As for some emerging industries recently cited for potential overcapacity, such as new energy vehicles and photovoltaics, they are primarily led by private firms. In these sectors, competition is fierce and the risk of market exit is high, meaning sustained investment expansion is unlikely if overcapacity persists.

Second, investment is a key component of aggregate demand, and there is still significant room for investment beyond the overcapacity sectors. There remains considerable potential in household consumption, particularly in the services sector. Investment in productive sectors creates jobs and increases household incomes, thereby supporting consumption and growth.

Another related concern is that SOEs behave like shadow banks. Because the PBOC sets loan growth targets for commercial banks, some SOEs can obtain low-interest loans even without viable investment projects. These funds are often redirected into wealth management products—a practice often labelled as “money circulating within the financial system.” While these distortions create longer credit chains, SOEs acting as shadow banks do contribute to lowering the yields of these financial products and consequently, reduce financing costs for borrowers. The behaviour of SOEs as shadow banks raises moral concerns for policymakers at the PBOC. Although this is a legitimate issue, it does not impair monetary policy transmission from a macroeconomic perspective and should not deter the central bank from maintaining an appropriately accommodative stance.

Lastly, the argument that monetary easing cannot stimulate household credit demand overlooks the impact of interest rate reductions on indebted households. Since 2024, measures have been rolled out to support consumer spending, but these primarily benefit households with savings or the capacity to take on debt. As the effectiveness of these measures is diminishing, monetary policy should shift its focus from “the growth of consumer loans and mortgage loans” to “alleviating the debt burden of indebted households” — with deflation and falling home prices, the real debt burden on these households is increasing. Once they fall into a debt–deflation trap, their consumption will decline even further. Currently, outstanding mortgage loans in the banking system total approximately 40 trillion yuan [$5.5 trillion]. A 200-basis-point reduction in mortgage rates would lower household debt-servicing costs by 0.8 trillion yuan [$110 billion]. If these savings were used for consumption, it could lift GDP by an estimated 0.6 percentage points.

3. Clearly Defining the Objective of Monetary Policy is Crucial

Longstanding experience in Japan, the Eurozone, and the United States shows that economies which have emerged from periods of low inflation (deflation) have all implemented extended phases of ultra-loose monetary policy, even zero interest rates. While an ultra-loose monetary policy alone is not sufficient to lift inflation—these economies also employed fiscal stimulus and structural reforms—ultra-low interest rates are a necessary condition. Low interest rates form the foundation for reducing government financing costs and enabling fiscal expansion, and they are also a prerequisite for stimulating credit demand in the private sector.

China now faces challenges similar to those once encountered by Japan. However, a major factor currently undermining the effectiveness of monetary policy is the lack of clearly defined objectives, which leaves the policy stance vulnerable to disruptions from external pressures.

First, monetary policy should return to its fundamental role as a tool for managing aggregate demand, with a focus on addressing macro-level risks such as inflation or deflation. It should not be constrained by micro-level concerns like “money circulating within the financial system” or overcapacity issues at the sectoral levels, nor should it be overly burdened with structural or sectoral objectives. While China does face issues such as an imbalanced investment–consumption structure and various distortions in its financial markets, this doesn’t mean that an accommodative monetary policy would necessarily exacerbate these problems. Furthermore, these problems should not become obstacles to further monetary easing.

Second, the government should shift its focus away from new loan targets and other quantitative measures and instead prioritise lowering interest rates to reduce debt-servicing costs for borrowers, helping them avoid the debt–deflation trap. Currently, weak credit demand in the private sector has reduced the marginal effects of traditional quantity-based tools, as banks are unable to meet their lending quotas. At the same time, in the absence of active fiscal support, the central bank faces challenges in sustaining money expansion. Although the PBOC has repeatedly emphasised the need to de-emphasise quantitative targets, in practice, it continues to rely heavily on such tools and use the quantitative measures as the sole measures of monetary policy stance. Given that China’s private-sector debt stands at around 200% of GDP, and that local governments carry significant hidden liabilities, it is urgent and essential to reduce the debt burdens of enterprises, households, and all levels of government is urgent and essential to revitalise aggregate demand.

Lastly, the PBOC and regulatory authorities should utilise macro-prudential policies and financial regulation to prevent financial risks from hindering further monetary easing. Policymakers have long been concerned that sharp interest rate cuts could trigger financial instability, including disruptions in the interbank market and depreciation of Yuan. While managing financial risks falls within the PBOC’s broader mandate, it should differentiate between policy instruments aimed at price stability and those focused on financial stability. In fact, the PBOC has already established a “twin-pillar” framework that integrates monetary policy with macro-prudential oversight. Within this framework, the macroprudential toolbox should be further expanded and refined to enhance the system’s capacity to identify and contain financial risks.

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