The natural interest rate in China

Summary

Focus

The ongoing development of China's financial system and its increased influence on global economic and financial conditions creates a need for tools to evaluate the stance of monetary policy in China. Key among these is an estimate of the natural interest rate – the real policy interest rate that would be consistent with a closed output gap and stable inflation over the medium run – in China. Previous attempts to estimate the natural interest rate have struggled to overcome the challenges posed by relatively short macroeconomic data samples and stable aggregate GDP growth statistics.

Contribution

We propose a method to estimate the natural interest rate for China. The key to our approach is to use multiple sources of information to form inferences about key unobserved variables, like the output gap and trend inflation. With these quantities in hand, we are able to identify the role of monetary policy in shaping macroeconomic outcomes in China and generate plausible estimates of the natural interest rate.

Findings

We find that the natural interest rate in China is currently around 2–3%. It was previously higher – at around 3–5% – between the late 1990s and 2010, before declining over the past decade. Real policy interest rates have generally tracked the natural interest rate closely, consistent with China's economy having a relatively small output gap for much of this time. Around two thirds of the decline in the natural interest rate in China reflects a decline in the rate of trend growth. The decline in the natural interest rate in China mirrors that in other economies.

Abstract

We estimate the natural interest rate in China. The natural interest rate averaged between 3 and 5 per cent between the late 1990s and 2010, but declined over the next decade to around 2 per cent. We attribute around two-thirds of the decline in China's natural interest rate to a lower rate of potential output growth. As the decline in the natural interest rate in China mirrors that observed in many other economies, it is possible that global factors explain part of the decline in the natural rate not explained by lower growth.

JEL classification: E32, E40, E44.

Keywords: real interest rate, natural interest rate, monetary policy.