MNI: PBOC’s New Overnight Tool To Lower Rates Over Time

The People's Bank of China's new overnight reverse repo tool will help lower overall interest rates as its influence grows, despite the central bank's cautious rollout aimed at tempering expectations of policy easing and limiting its immediate impact on money markets, economists and advisers told MNI.

The PBOC launched the overnight reverse repo facility in its open market operations this week using a fixed-rate, quantity-tender approach, injecting CNY300 billion on Monday and CNY600 billion on Tuesday.

Dong Ximiao, chief economist at Merchants Union Consumer Finance, said the PBOC's decision not to disclose the interest rate immediately reflected caution during the pilot phase of the new instrument, as policymakers wanted to assess the market's reaction while avoiding an overinterpretation of the move as a rate cut. Sources later confirmed the rate was set at 1.25%, unchanged over the two days and below the market expectation of 1.35%.

The tool would complement the existing seven-day reverse repo by providing a shorter maturity, allowing the central bank to manage liquidity more precisely, Dong added. (See MNI INTERVIEW2: PBOC Short-Term Rates Focus To Cap Volatility)

Sources also said the Bank withheld the rate to avoid fuelling expectations of policy easing that could have pushed the DR001 rate lower. Weak credit demand left the interbank market awash with liquidity in April and May, driving the DR001 rate down to 1.20%, well below the 1.4% policy rate, prompting the PBOC to drain liquidity to push DR001 back higher. Since June, DR001 has gradually recovered to around 1.4%. On Monday, however, the weighted average DR001 rate fell 5.4 basis points from the previous trading day to 1.30%.

The PBOC intends the new facility to serve as a neutral tool in its initial phase to smooth liquidity at critical times, meaning its immediate impact on funding rates remains limited, sources told MNI. The central bank did not conduct overnight operations on Wednesday.

LOWER RATES

Lian Ping, director of the China Chief Economist Forum, said because the overnight repurchase rate is below the seven-day reverse repo rate, its growing role as the policy benchmark in future would gradually pull down overall interest rates, particularly given the limited scope for conventional policy rate cuts.

Dong noted the facility is designed to better meet cross-quarter liquidity demand at the end of the first half, when banks face funding pressures due to end-June regulatory assessments, while also allowing the central bank to respond more flexibly to intraday liquidity needs. 

He argued the move represents an important step toward making the overnight reverse repo a regular policy instrument since the PBOC began building its interest rate corridor in 2024, improving management of short-term interest rates. (See MNI: PBOC Targets Monetary Policy Reform Via Overnight Rate)

LIQUIDITY STANCE

The new tool has done little to ease market concerns that the central bank will continue draining liquidity. Despite the PBOC's overnight injections this week, seven-day reverse repo operations recorded a net withdrawal, resulting in a rare net drain of CNY174 billion at quarter-end.

The overnight reverse repo effectively replaced part of the maturing seven-day reverse repo operations with shorter-term funding, helping prevent excess liquidity from idling in the interbank market and mitigating the surplus liquidity created by weak credit demand, sources said.

Lian explained that as bank lending becomes less dominant and bond, equity and money market financing play a larger role, money market rates will fluctuate more frequently, increasing the need for the overnight rate to become a policy benchmark. While replacing the seven-day reverse repo with the overnight rate as the key policy rate is the long-term direction, further progress is needed in interest rate liberalisation, policy transmission and liquidity circulation, he said.

To some extent, the Federal Reserve's decision to keep interest rates unchanged, or even raise them further, has constrained the PBOC's room to cut rates. Moreover, with borrowing costs already low and credit demand weak, an additional 10bp cut would likely do little to stimulate the economy.

MNI INTERVIEW: ECB Strategy For Uncertain Times -Kazaks

The eurozone remains exposed to negative supply shocks with near-term risks still posed by the wars in the Gulf and Ukraine and global trade rules, underlining why the European Central Bank is right to step away from complex forward guidance to data-led policy, Bank of Latvia Governor Martins Kazaks told MNI.

"What we've seen is that one shock doesn’t play out, but a second comes along. The shocks tend to lay on the top of each other, complementing and interacting with each other," said Kazaks, who declined to comment on possible policy options over the next few months, as other Governing Council officials indicate that a further rate hike in September is not guaranteed.

"We stick with the meeting-by-meeting, data dependent approach as uncertainty remains very high," Kazaks said in an interview at the ECB Forum in Sintra, adding that the ECB's policy destination "is very clear," having to "deliver 2% inflation medium term, that's our target". 

Risks to the outlook also include global trade conflict and extended equity valuations, he said.

"The frothiness in the equity markets driven by the AI boom and the risk of a sharp market correction that might spill over the wider economy globally," is a concern, said Kazaks, adding that Europe’s economy also faces longer-term issues identified in the Draghi and Letta Reports including "structural adjustments and how successful Europe is going to be improving its productivity growth." (See MNI INTERVIEW: ECB 'May Have To Do A Little Bit More' - Wunsch)

POLICY FRAMEWORK

The ECB's strategy of stepping away from “complex'” forward guidance to a data-led approach, as outlined by its President Christine Lagarde in her June 29 Sintra speech "is absolutely in line with [last year’s] strategy review update. The target is still the same, the reaction function is still the same, forceful and persistent is still the same," Kazaks said.

"Forward guidance is a good instrument to use when you get close to effective lower bound -- but we are not there at the moment," he added. (See MNI INTERVIEW: September Hike Not Guaranteed - ECB's Demarco)

IRAN FALLOUT

While the economic fallout from the Iran conflict has been more limited than those of the Ukraine War or the reopening shocks post-Covid, it is not negligible, the Latvian central bank chief said.

"The shock is smaller than the past shocks that we've seen, but it was there for three to four months and there are some [price] mechanisms that have already been put into motion," he said.

"That means we cannot through look through this shock and that's why we acted by hiking the rates by 25 basis points in June," he added.

Kazaks added that recent debate over a slight rise in the neutral rate, reinvigorated by comments by Chief Economist Philip Lane, was of little importance to the current policy debate.

"The neutral rates is unobservable, so it's a theoretical concept, and the most quoted range is 1.75% to 2.5%.  With the discount rate at 2.25%, I think we're very clearly still within the neutral range, so the rates are not constraining significant economic growth," he said.

MNI INTERVIEW: Price Falls Supports US Factory Growth - ISM

Falling energy prices are likely to support ongoing growth and potentially fresh hiring in coming months for a manufacturing sector that experienced a steadying of growth last month, Institute for Supply Management manufacturing chair Susan Spence told MNI.

"If the situation in the Middle East really does improve and the prices continue to drop, which I think you will see that given oil prices, then I think it fuels the expansion," she said in an interview Wednesday. 

The ISM manufacturing index eased 0.7ppts to 53.3 in June, slightly below market expectations. The headline measure has been in a narrow range between 52.4 and 54.0 in each of the first six months of the year, after almost all of the prior three years just below 50. 

The report details point to a positive outlook for the sector. Sentiment among survey respondents broadly improved and the decline in the prices paid index bodes well for future growth, Spence said. "I'm overall optimistic, and this is the third month in a row."

The prices paid Index fell to 73.0 from 82.1, the largest one month decline since 2022. The new orders index eased to 56 from 56.8. The employment index rose 1.1ppts to 49.7. While the employment index remains in contraction, it's the highest since January 2025.

ENERGY PRICES 

With oil prices receding and the Strait of Hormuz more open than before, supply side indicators began to improve last month. "If oil prices hold and they don't go back up, there's a host of commodities that should settle down," she said. There were 27 commodities reported up in price versus 5 reported down in price, and 5 commodities were in short supply.

Spence laid out a potential path in which the U.S. central bank could see gains in both employment and price stability, perhaps obviating the need for upward rate adjustments. (See: MNI INTERVIEW: Fed’s Next Rate Move Most Likely Upward-Kohn) 

"If the prices index could settle back toward 50, it almost feels like equilibrium there, then I think the inflation worries die down," she said. "If there is an increase in employment, I think they're in a really good state. Then that'll certainly influence the Fed's decision, although they'll look at more than just manufacturing."

Spence, however, remains concerned about the path of tariff policy under the Trump administration. "The bad guy in the shadow is, what's going to happen with these 232 tariffs?"

MNI INTERVIEW: Fed Right To Hold Off On Hikes For Now - Keen

The Federal Reserve should wait to see how much inflation comes down in the next few months following an easing of Middle East tensions that have brought oil prices sharply lower, Benjamin Keen, a former consultant and visiting scholar at several regional Fed banks, told MNI. 

“A lot of the inflation was being driven by oil prices, and we’re starting to see oil prices go down. I would expect in the coming months for that to show up in the data,” he said.  

“The Fed still wants to get the economy back to its long run 2% inflation target,” said Keen, adding that whether rate hikes will be needed to achieve that outcome has “yet to be determined.”

Fed officials are right to be worried about above-target inflation, and Chair Warsh’s focus on price stability is understandable given economic conditions and his priors as a Fed governor during the 2008 financial crisis, said Keen. (See MNI INTERVIEW: Fed Can't Ignore Mounting Prices Pressures-Liang) 

NO RUSH 

Still, the direction of price pressures is not uncertain, and Warsh and the FOMC are probably right to take their time before rushing into any tightening move. 

“Based on what they’re seeing in the data, that seems to be a reasonable course of action,” said Keen, an associate professor at the University of Oklahoma. 

Like Warsh, Keen is optimistic about the prospect that the AI boom could unleash a new wave of productivity that also helps keep a lid on prices. 

“We could raise the natural rate from productivity build out, but as AI comes along and lowers per unit production cost, those will eventually be passed on to the consumer in terms of lower prices or lower growth in prices, which means what productivity shocks are disinflationary,” he said.

At the same time, the labor market is showing little hint of the kind of weakness that would require more accommodative policies from the Fed, said Keen.

“The macro data does not show the labor market needs support.  We do have a segment of the labor market, recent college graduates, that we have a problem with. But overall the macro environment looks good. That’s the Fed’s job, to worry about the overall macro. The Fed doesn’t need to be in the business of targeting unemployment rates for groups,” said Keen.

CONSENSUS

Warsh is trying to build consensus not just on the path of interest rates but also on his stated push for reform in areas like communications and the balance sheet, Keen said. 

The chair is right to shun forward guidance in a highly uncertain environment, he added. 

“It’s the assessment of the chair that forward guidance is tying our hands to some degree,” he said. “There’s a benefit to doing it when we are at the zero lower bound, but right now it comes with a greater cost because if the market is expecting one thing and they’re doing something different because new information has come in, then it’s going to catch the market by surprise.”

The Fed is still likely to want to avoid major market surprises, but the shift in communications approach could throw some curveballs.  

“We've gotten used to the current paradigm for a while, and now what he's suggesting is let's change that paradigm, and let's go back to, we walk into every meeting, we have a discussion on the facts on the ground, and the data that we're seeing,” Keen said. 

MNI INTERVIEW: Fed Will Be On Hold As Oil Shock Unwinds- Levy

The Federal Reserve is likely to keep interest rates on hold as the oil shock from the Middle East conflict unwinds and a temporary drop in prices raises the real fed funds rate, Mickey Levy, an outside advisor to several Fed Banks, told MNI.

"I doubt if the Fed would vote to raise rates in an environment in which the general price level is declining," said Levy, a member of the Shadow Open Market Committee, a group of private academic economists that acts as the Fed’s outside watchdogs. 

"The Fed's not going to raise rates when the when the CPI or PCE price index are declining," Levy said. Financial markets are pricing in only about a 30% chance ​of a rate hike at the central bank's July 28-29 meeting. (See: MNI INTERVIEW: Fed’s Next Rate Move Most Likely Upward-Kohn) 

Levy said this FOMC is on hold waiting for more data with the hope that core inflation recedes a bit, rather than having "its finger on the trigger to hike rates." 

UNWIND

The dramatic spike in oil prices generated three months of outsized increases in CPI and PCE inflation that pushed up their year-over-year measures. Oil prices have fallen sharply, and if current prices stick close to current levels, which is uncertain as inventories need rebuilding, continued rapid price declines in gasoline and other energy may result in months of decreases in the CPI and PCE price index.

"I think June's going to be the transition month in terms of the monthly inflation data, but in July and August you could have outright declines in the CPI and maybe the PCE," he said. "I can't remember when we've had such a period with oil where there's been a surge like we had on the way up and then a collapse on the downside. It's just striking."

This would ease some price pressures on consumers and let the Fed breathe more easily. The consumer in the last three months has been resilient, Levy said. "Consumption has been rising in real terms each month and you've got a nice bounce in employment." (See: MNI INTERVIEW: Fed Hike Plausible As Early As July - George) 

Levy, a visiting fellow at the Hoover Institution, also noted that retail gasoline prices have fallen rapidly and the labor market is at maximum employment. 

In its updated June Summary of Economic Projections, the FOMC members estimated that a rate hike may be appropriate to be consistent with its dual mandate goals. "But the FOMC member dots are not binding, and subject to changing conditions," Levy said. 

DELIBERATE

MNI INTERVIEW: ECB 'May Have To Do A Little Bit More' - Wunsch

A lasting ceasefire in the Persian Gulf pushing oil and gas prices lower may shield the eurozone from significant second-round inflation effects, but some impact is inevitable and the European Central Bank may have to hike again, Belgian National Bank Governor Pierre Wunsch told MNI.

"We may have the shock disappearing before materialisation of any significant second round effects, but we are going to have some, so maybe we have to do a little bit more," Wunsch said in an interview at the ECB Forum in Sintra.

Speaking ahead of the publication on Wednesday of preliminary June data showing a decline in euro area annual inflation to 2.8%, Wunsch said "the July [inflation] number is probably going to be good on the low side, a downside surprise, and you don't want to hike on a downside surprise."

"But in September we're going to have a new projection, and some more visibility on the second-round effects," he noted. (See MNI INTERVIEW: September Hike Not Guaranteed - ECB's Demarco)

DON'T HESITATE

If the ECB needs to hike, it should not hesitate to act when the time comes, Wunsch said.

The question now is, and this is where I might differ a little bit from my colleagues, is if we need -- and I'm not saying that we need one -- but if we need another hike, I wouldn't wait too long," he said.

"I'm not pleading for a hike, I'm just saying if, if we see enough second-round effects that we believe we should be doing more, then don't wait too long,” Wunsch said. “We know inflation is going to be above target for a while. If we feel we need another hike, if the data tells us and data analysis and models say that we need the second hike, I would not hesitate too much." (See MNI INTERVIEW: ECB Ready To Hike Or Change Course - Kocher)

ROBUST MOVE

Wunsch did not think the ECB's June hike could possibly come to be seen as a serious policy mistake whatever the inflation outcome, but as a robust move, consistent with the data.

"We have to accept that we live in an uncertain world, and that we're going to take decisions sometimes not knowing what's going to happen the next day. But I think inflation is going to be above 2% for a while, so if you tell me that was a mistake ...." he said.

"We don't know when we are going to be at an inflection point, so that's when you can make a small mistake, but it would only be a small mistake. Real rates are going down, so I don't think there is any argument saying it was a mistake."

GUIDANCE

Referring to President Christine Lagarde's speech indicating that the ECB was moving away from “complex” forward guidance, Wunsch agreed that the Governing Council's ongoing data-dependent, meeting-by-meeting approach was correct.

However, he added that at times there would be room for guidance of some sort.

"We are not going to copy and paste meeting-by-meeting, data dependent for the next five years. At some point, it won't mean anything. Sometimes we can allow ourselves to give some kind of guidance, for example, I said in March ‘I guess if this conflict is not done by June, we're going to have to hike,’” he said. "I would not exclude that you need to give a signal, it might be a conditional one, a very cautious one, like if this unfolds, then we might have to do this.”

MNI INTERVIEW: September Hike Not Guaranteed - ECB's Demarco

The bigger-than-expected drop in energy prices and encouraging data including a fall in core inflation mean there is no reason for the European Central Bank to rush into any further interest rate increase, Bank of Malta Governor Alexander Demarco told MNI, adding that a hike in September is not guaranteed.

“If both the data which is coming out and the new projections in September continue to show that the baseline or milder scenario still holds, we could have a reason to hike again. But if the actual data shows that things are better than what we expected of indirect effects on inflation, maybe there is no need for another rate hike in the end,” he said in an interview on the sidelines of the ECB Forum in Sintra.

“I think time is a bit in our side in the absence of any dramatic developments,” he added, though he noted that even the ECB’s milder scenario, which now seems to be materialising, implied another rate hike.

“The question is now the timing, because I think, given that oil prices have gone down so much, we have to see what the data will tell us.”

Oil prices are now lower than the projections in the milder scenario, though futures prices are still between the mild and baseline scenarios, said Demarco, adding that while cheaper energy could have positive implications for short-term inflation expectations, the U.S.-Iran ceasefire is fragile and uncertainty persists. (See MNI INTERVIEW: ECB Ready To Hike Or Change Course - Kocher)

MILDER SCENARIO DISCUSSION

Demarco admitted that he had initially shared reservations with some other Governing Council members regarding the inclusion of the mild scenario in the ECB’s June projections.
“I thought, at that time … the milder scenario was not very likely to happen,” he said, noting that prospects for rapid agreement between the U.S. and Iran had appeared remote during the June meeting. However, he added, “I saw the rationale also for including the milder scenario because … even though it may have seemed less probable to occur … it would confirm the need for the rate hike in June … So from that perspective, I  went along with the decision and I think it was a good decision to include the mild scenario.”

CORE INFLATION KEY

For Demarco, the most important signal in recent inflation releases came from the fall in the core gauge, which he took as a sign that higher energy costs are not feeding through broadly into the economy more than expected.

“Core inflation, even though we do not target core inflation per se, is a very good indicator where inflation is heading,” he said, noting that headline readings can be distorted by temporary movements in energy prices due to tax measures.

“You could have oil prices falling sharply, and that will be definitely a strong negative effect on overall HICP. But if you have core inflation rising, and maybe the drop in energy prices temporarily offsetting that, you could think that inflation has gone down. But the dynamics would be still worrying in that respect,” he said.

 “Core can be the change of dynamic to see, like, things are starting to improve.”

AI, R* AND EXCHANGE RATE

The ECB has slightly raised its estimate of the neutral rate, but Demarco was cautious as to any suggestion that this might reflect productivity gains linked to artificial intelligence.

“I'm not too sure that it's really AI pushing up this,” he said, arguing that cyclical factors linked to the energy shock and higher defence spending may be playing a bigger role. Policymakers should wait until the effects of the latest shock dissipate before drawing conclusions about the long-term implications for monetary policy and the neutral rate, he added.

Demarco said recent euro weakness against the dollar was largely irrelevant from a monetary policy perspective. A move from around USD1.16 to USD1.14 was “not a dramatic effect,” he said, attributing most of the adjustment to changing expectations around Federal Reserve policy rather than any deterioration in the euro area outlook.