Interest Rate-based Multi-objective System

The intermediate target of monetary policy is a medium process of monetary policy transmission mechanism and the medium variable between monetary policy and the final target of monetary policy. It is also the link connecting the monetary policy of the central bank and macro-economy. The choice of the intermediate target is directly relating to final targets. Generally, the intermediate target has three characters: mensurability, controllability, and relativity.The central bank may use different monetary targets under different economic environments. The intermediate targets of the monetary policy of main western countries covered a process of converting from quantity type instrument to price type instrument. As it was in America, Federal Reserve Bank used money supply and interest rate as intermediate target early, but now is regulated by Taylor Rule. In current western countries, interest rate, exchange rate, money supply, inflation targeting are mainly chosen.Under the planned economy mechanism, China monetary policy mainly worked through credit program for a long period. The central bank has strengthened the macro-control of market instruments along with the progress of economy mechanism reform. In 1990s, the direct target of economic control began to transit to indirect ones. The central bank announced in 1995 that money supply became one of the monetary policy targets, and began to release annual target of money supply control since 1996. The fifty-year's loan scale limitation was lifted on Jan 1, 1998, from when on money supply formally became the intermediate target of China monetary policy.Such choice was then adaptable to China economic environment and achieved great progress: China economy maintained a good development trend, successfully resisted the Asian financial crisis, and effectively controlled inflation rate. However, as China accelerated its steps forward economic globalization and deepened its financial mechanism reform, the economic and financial environments have witness great changes with monetary endogenous getting more significant. Since the twenty-first century, trading surplus and RMB appreciation pressure resulted in weakened control power of the central bank against the RMB counterpart of foreign exchange reserves, enlarged fluctuation of money multiplier, and weakened controllability of money supply. In the period from 2001 to 2006, M2 real growth deviated from the target value by 20% in average; while M1 growth was also out of control, so that the central bank no longer released the M1 growth target of the year since 2007. Statistics indicate that the mensurability and relativity of money supply are also weakening annually. We now confront with a problem to choose a substitute from credit, interest rate, and exchange rate, since money supply is no longer competent for its role of intermediate target of monetary policy.Credit, which was suitable for the planned economy and the transitional environment from planned economy to market economy, was the direct target of China macro control under the planned economy mechanism. Whereas, given the establishment of market economy mechanism in China, credit is unsuitable to be the intermediate target of monetary policy especially that the loan scale is becoming intractable in recent years.Interest rate is also not suitable for the intermediate target of China monetary policy due to several reasons: The interest rate approach is appropriate to small-sized country with open economy and long-term equilibrium of balance of international payments. But China is still a developing country with RMB exchange rate under government control and China has maintained a significant trade surplus for a long period.As for inflation targeting, although hot discussed in the present economics field, such measure is still not suitable for China. The implement of inflation targeting requires one country to make a reasonable range of inflation target; to calculate and forecast the inflation rate accurately; and to give its central bank high dependence that the central bank is only responsible for the inflation rate, and could take any measures it thinks right to achieve the inflation target without any curb from other departments. However, on one side, China cannot accurately calculate and forecast the inflation rate with indefinite range of inflation target and immature technology of economic data collection and processing; on the other side, China central bank is lack of sufficient dependence. Another crucial point is that China's central task is focusing on economy development as a developing country with relatively backward economy. Hence, if China central bank mainly focused on the inflation rate, it would just deal with the price index but ignore other macroeconomic targets.In contrast, interest rate is the most favorable instrument and development orientation of the intermediate target of China monetary policy. As the accelerated interest rate liberalization reform in China, the controllability, mensurability and relativity of interest rate is becoming stronger, and the quantity type instrument centering on interest rate is making greater function during monetary policy transmission.China currently has two sets of interest rate system: official interest rate and market interest rate. The former is the most important part, while the latter has begun to rapidly develop since the interbank offered rate was unloosened in 1996. From 1990s on, the central bank has adjusted official interest rate for several times and meanwhile taken steps to reform the interest rate liberalization, in order to regulate the macroeconomic somewhat through interest rate. The positive results of those adjustments in recent years show that interest rate is fundamentally qualified to be the intermediate target of monetary policy.China interest rate liberalization is still imperfect, especially that the deposit and credit rates which are the main body of China interest rate system and whose benchmarks is determined by the State Council, have lower liberalization level. However, interest rate actually could act as the operation target of monetary policy if only the transmission is effective. For example, American Federal Reserve Committee determines the benchmark rates although American interest rate already realized liberalization. The key problem is whether the interest rate policy is scientific and prospective, and whether the interest rate adjustment can be effectively transmitted to the real economy. In view of the dramatically improved scientificaalness and foresight, relatively dependent policy making by the central bank, and more significant impact on macroeconomy through interest rate adjustment, the time is ripe for China to take interest rate as its target of monetary policy control.But interest rate liberalization is still an important condition for interest rate to play its adjustment function to the full. The interest rate channel could be more effective only if the liberalization realizes. Due to the lower liberalization level, China official interest rate cannot function to reflect market information effectively, besides which the microeconomic benchmark rates flexibility is relatively low, hence interest rate cannot dependently be the intermediate target of monetary policy at present. Under such situation, the multiple target mechanism with an interest rate base might as well be an ideal solution.Interest rate is the core of multiple target mechanism. Because the main parts of China interest rate system are deposit and credit rates, it is necessary to make full use of the leading role of deposit and credit benchmark rates, and pay great attention to market rate impacts on economy as well. What's more, money supply should also be taken into account. Given significantly weakened controllability, mensurability and relativity, money supply could act as a subsidiary intermediate target of monetary policy. Benefiting from the successful experience of Taylor Rule, we should comprehensively refer to several macro indexes including the real output, inflation rate, credit and exchange rate, etc. when using interest rate to make macro control.In brief, interest rate is the ultimate choice for China intermediate target of monetary policy. But considering China's current situation, the monetary policy control cannot be achieved only through interest rate. Hence, multiple target mechanism focusing on interest rate will be a feasible approach. That is to regard interest rate as the intermediate target of monetary policy, while money supply as a subsidiary target, and meanwhile pay attention to inflation rate and exchange rate, etc. China has to accelerate its liberalization of interest rate, improve the transmission mechanism of interest rate in monetary policy and RMB exchange rate formation mechanism, and finally establish interest rate as China intermediate target of monetary policy in the fullness of time.