Mitigate the Pressure of Spreads Narrowing with Moderate Inflation Easing

Abstract: Structural factors are necessary conditions and long-term determinants for a low-interest-rate environment, but they are not sufficient on their own. In China, certain structural factors combined with low inflation have led to the current low-interest-rate environment. Theoretically, the interest margin represents the difference between asset and liability rates. If both rates are reduced in tandem, a low-interest environment does not necessarily lead to a narrowing of the interest margin. However, due to the lower bound on nominal interest rates in China, the pressure for narrowing margins becomes more pronounced when nominal rates can no longer be lowered.

Under these circumstances, the only solution is to increase nominal price levels to sustain moderate inflation. However, China is not yet fully prepared to adopt an inflation targeting framework. In the short term, a nominal GDP target may be a more suitable macroeconomic management model, as it combines inflation targeting with counter-cyclical adjustments. This approach is also easier for local governments to understand and implement effectively.