China's central bank shakes up its monetary policy

The People's Bank of China (PBOC) is changing how it steers the country's monetary policy, moving towards controlling interest rates directly rather than adjusting the money supply.

The PBOC threw markets a curveball this week with an unexpected sequence of rate cuts.

It first lowered several key rates, including the loan prime rate and reverse repo rate on Monday, followed by an unscheduled cut to its medium-term lending facility rate on Thursday.

Previously, changes to the medium-term lending facility typically preceded other rate adjustments. Experts say this shift could have major implications for the Chinese economy going forward.

"It is basically a coordinated effort across all the key interest rates to ease monetary policy," said Lynn Song, Greater China chief economist at ING Bank. "It's worth highlighting this round of easing kicked off with the seven-day RR, which may be a signal of its future role as the main policy rate."

These back-to-back rate cuts indicate that China is looking to prop up an economy that fell short of expectations in the second quarter due to weak consumer spending.

The PBOC had previously held off on rate cuts since late last year, aiming to maintain stability in the yuan exchange rate.

Repo rate as a key benchmark

The PBOC trimmed the seven-day reverse repo rate to 1.7% from 1.8%, along with another adjustment to the loan prime rate.

Three days later, it conducted an unscheduled medium-term lending facility (MLF) cut, slashing the one-year MLF rate by 20 basis points to 2.30%— the largest cut since April 2020.

"The arrangement of the MLF operation after the LPR further downplays the policy rate significance of the MLF, indicating that changes in the rate do not carry policy signal implications," according to the PBOC-backed Financial News.

This move follows recent statements from PBOC Governor Pan Gongsheng at the Lujiazui forum in June, where he indicated that the seven-day reverse repo rate would become the key benchmark.

Investors are closely watching the PBOC shift

The shift to direct rate control aligns China more closely with many developed economies, giving the PBOC more flexibility to respond to economic conditions and steer market expectations.

Investors are closely watching these changes, especially given the recent bond market volatility in China.

There's growing anticipation for measures to support the economy and manage cash flows, potentially affecting bond prices. As a result, investors will likely begin to focus more on short-term rates as key indicators of the PBOC's policy stance.