During the Federal Reserve's aggressive interest rate hikes, Silicon Valley Bank and Credit Suisse successively encountered liquidity crises, triggering panic in the financial markets, which have not yet been fully calmed. Affected by the recent closures of banks in the United States, European stock markets continue to be turbulent, and the banking industry is under constant pressure, with Deutsche Bank becoming another risk point in the eyes of the market. In the context of highlighted international financial risks, our country's central bank has timely lowered the reserve requirement ratio, which has a positive significance for enhancing the liquidity of our country's banking system and maintaining our country's financial security. Similar to the previous two times of lowering the reserve requirement ratio, the central bank's reduction this time is also relatively small, at 0.25 percentage points, reflecting the process of "trial and error" in monetary policy.

How to understand the "trial and error" of monetary policy? We believe that the decision-making of monetary policy is not only a passive response to the operation of the economy but also needs to actively test market reactions and make decisions based on the situation. For a long time, there has been a debate about whether monetary policy should follow a single rule or make decisions based on the situation. The "single rule" advocates that monetary policy operations should be carried out according to rules, maintain the stability of the currency value, and enhance the credibility of monetary policy. However, in reality, monetary policy often faces more constraints. Making decisions based on the situation has higher flexibility and can better adapt to complex and highly uncertain market environments. Practice has proven that it is difficult to implement monetary policy following the "single rule". As early as the 1970s and 1980s, the Federal Reserve tried to implement monetary policy based on the single rule of money supply, leading to large fluctuations in interest rates. Later, due to a series of market changes such as financial innovation, the Federal Reserve had to abandon this goal. The 2008 international financial crisis also challenged the Federal Reserve's monetary policy rule dominated by the Taylor rule. With the current federal funds rate rising to a higher level, the forward guidance of monetary policy provided by the Federal Reserve increasingly shows the characteristics of making decisions based on the situation.

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Monetary policy is often "one step at a time, looking one step ahead".

I. The debate between "single rule" and "making decisions based on the situation"

The debate about whether monetary policy should be carried out according to a single rule or making decisions based on the situation has a long history, and both have their pros and cons. Making decisions based on the situation reduces the money supply during economic prosperity to prevent the economy from overheating; during economic recession, it increases the money supply to increase effective demand and promote economic growth. Its flexibility is high, but it lacks expectation management, and the policy lag is difficult to grasp. Moreover, the subjective arbitrariness of policy implementation may challenge monetary discipline, which is not conducive to currency stability and maintaining the credibility of the monetary authority. Although the "single rule" is beneficial for enhancing the credibility of monetary policy, there is a problem that the rule does not adapt to real constraints, because the market is often unpredictable and full of uncertainty. It is difficult for the monetary authority to accurately predict future economic and financial operations and their changes. If the implementation of monetary policy sticks to the rule, the central bank loses its ability to respond to economic crises and regulate the economy. However, if it does not follow the rule, the central bank will lose the trust of the public.

From a theoretical perspective, Keynes's theory on monetary policy operations has obvious characteristics of making decisions based on the situation. Its policy proposition is that when the economy suffers from unforeseen external shocks, the monetary authority uses monetary policy based on the situation to respond in time, which can maintain the stability of economic operations. However, the monetarism represented by Friedman believes that money is neutral in the long term. Due to the difficulty of grasping the lag of policy effects, monetary policy based on the situation may cause new shocks to the economy. The money supply should grow at a fixed rate. In the 1990s, Taylor proposed a monetary policy rule based on the output gap and inflation rate, namely the "Taylor rule", which believes that the adjustment of nominal interest rates should be closely linked to inflation rates and economic growth rates. Both Friedman's operational method of setting the money supply as the target of monetary policy and the Taylor rule are specific manifestations of the single rule of monetary policy.

In practice, although making decisions based on the situation has been repeatedly challenged, most countries still use monetary policy based on the situation. Regardless of the fact that the neutrality of money itself is still controversial, monetary policy is often focused on the medium and short term. Another important reason is that making decisions based on the situation can better meet various constraints in economic operations, especially in situations with high information costs and large uncertainties, which can reserve more space for policy adjustment in a timely manner, and even "trial and error".

II. Why does monetary policy need "trial and error"?

Unlike fiscal policy, which can directly intervene in economic activities, monetary policy generally plays an indirect role and requires the cooperation of commercial banks and even the entire financial system. The effectiveness of its implementation is largely affected by market feedback. The effect of monetary policy is often asymmetric. Generally speaking, tight monetary policy is more likely to have an impact on the economy, while when the economy faces downward pressure and needs to encourage credit expansion through liquidity easing, commercial banks often "hoard loans". The process of the central bank's loose monetary policy being transmitted to the real economy will be blocked, and the excess reserves of commercial banks will increase significantly (for example, after the 2008 financial crisis, the excess reserve rate of US commercial banks increased unusually). The transmission mechanism of monetary policy is also more complex than that of fiscal policy, and the transmission channels are generally longer, which are not fully controlled by central banks.

Another important reason is that it is difficult to accurately grasp the "lag" of monetary policy. The former chairman of the Federal Reserve, Martin, once said that the task of the Federal Reserve is only one, that is, "to take away the big wine glass at the beginning of the banquet". As we all know, there is a certain lag from the implementation of monetary policy to its impact on the economy, but the length of the lag is often uncertain. For example, when raising interest rates to deal with economic overheating, the policy lag may lead to the problem of over-tightening; on the contrary, during the economic recovery process, if the loose monetary policy does not exit in time, it may also cause inflation to get out of control, or lead to a surge in asset prices and affect financial stability. The central bank manipulates monetary policy with the "visible hand", and its decision-making is constrained by limited information. During periods of economic change, it is even more difficult for the central bank to grasp the degree of loosening or tightening. At present, the duration of the Federal Reserve's interest rate hike process also faces the same problem, and it is difficult to say that there is no risk of over-tightening in this round of aggressive interest rate hikes by the Federal Reserve. Data shows that the loan standards of US commercial and industrial loans continue to increase (that is, the willingness of banks to lend is decreasing), while loan demand has rapidly declined. The more obvious the divergence between the two, the greater the risk of economic recession. In such a situation, the "trial and error" of monetary policy can provide more market feedback for policy-making.When faced with significant uncertainty, monetary policy more than ever requires a "feeling the stones while crossing the river" approach. In reality, the formulation of monetary policy is a complex decision-making process, subject to numerous constraints. Since the 2008 international financial crisis, the "zero interest rate" has been a significant constraint on monetary policy. Former Federal Reserve Chair Janet Yellen proposed that the "Taylor Rule" did not consider the particularities of monetary policy in crisis scenarios, underestimating the necessity of maintaining an accommodative monetary policy stance at that time. This is because the equilibrium value of the actual federal funds rate that matches the medium-term full employment target should be far below the historical average, implying that the interest rate values implied by the "Taylor Rule" were significantly too high, constraining economic recovery and thus difficult to serve as a basis for monetary policy decisions. To maintain financial stability, it is necessary to pay special attention to tail risks, that is, to take seriously low-probability events that may bring about severe economic consequences. When tail risks exist, monetary policy should prioritize the pursuit of financial safety and liquidity rather than being confined to its medium- to long-term objectives.

Over the past year, the Federal Reserve's policy has undergone sharp short-term changes, causing financial market turmoil, indicating that the Fed has neglected to consider uncertain factors. Fed Chairman Powell, in order to maintain the credibility of the Federal Reserve, has combated inflation at a historically rare speed, which can be seen as a mixed bag. The Fed has achieved phased success in preventing inflation expectations from getting out of control. However, due to the difficulty of monetary policy in addressing, and even potentially exacerbating supply constraints, not to mention dealing with structural issues in the economy, the price paid by the Fed in the latest round of interest rate hikes has also been considerable.

III. China's consecutive small-scale reserve requirement ratio cuts reflect the process of monetary policy "trial and error"

The People's Bank of China decided to lower the reserve requirement ratio for financial institutions by 0.25 percentage points (excluding financial institutions that have already implemented a 5% reserve requirement ratio) on March 27, 2023. This is the third time in the past year that China's central bank has slightly lowered the reserve requirement ratio. Previous adjustments to the reserve requirement ratio were often by 0.5 percentage points, and sometimes even adjusted by 1.0 percentage point at once (such as in April 2018). The central bank's consecutive small-scale reserve requirement ratio cuts reflect the process of monetary policy "trial and error."

Firstly, monetary policy maintains flexibility and moderation according to economic changes. The most recent economic downturn in our country began in the second half of 2021, and the central bank lowered the reserve requirement ratio by 0.5 percentage points twice that year. At the beginning of 2022, the economy began to stabilize, but was impacted by the pandemic again in March. Under the circumstances where the impact of the pandemic shock was difficult to predict accurately, the central bank lowered the reserve requirement ratio by 0.25 percentage points twice. In March of this year, the reserve requirement ratio was lowered by another 0.25 percentage points.

Secondly, as financial market interest rates rise, it is necessary to maintain a reasonable and sufficient liquidity. The 7-day repurchase rate for deposit financial institutions has risen from around 1.4% at the beginning of this year to over 2.0%. At the same time, under the circumstances where international financial risks are prominent, it is also necessary to enhance the liquidity of China's banking system and promote financial stability. On the day the central bank announced the reserve requirement ratio cut (March 17), the renminbi slightly appreciated against the US dollar, with the onshore exchange rate of the US dollar against the renminbi closing at 6.8765, and China's exchange rate remained generally stable. From the market's reaction, this small-scale reserve requirement ratio cut by the central bank is appropriate.

Thirdly, it is in line with the overall economic goals for this year. The expected target of around 5% GDP growth and a 3% year-on-year increase in the consumer price index implies that monetary policy should support stable economic development without resorting to "flood irrigation," overdrawing the future, and should also consider the time lag of monetary policy. In the process of economic recovery, the issue of rising prices should always be highly valued, as there are still a large number of low- and middle-income groups in our country, and they are very sensitive to price changes. At the same time, changes in asset prices should also be highly concerned. In February of this year, the housing price index of 100 cities stopped falling month-on-month; looking at the prices of new commercial housing in 70 large and medium-sized cities, the month-on-month growth rate of housing prices in first- and second-tier cities has turned positive from negative. Therefore, the magnitude of the reserve requirement ratio cut also reflects the comprehensive consideration of monetary policy in achieving multiple goals.

In summary, the "small steps" of monetary policy, while maintaining a reasonable and sufficient liquidity, avoids "flood irrigation," and is also conducive to risk prevention. In the process of economic stabilization and recovery, China's monetary policy will still face a reality where opportunities and risk challenges coexist, and the number of unpredictable factors increases. A prudent monetary policy that is "accurate and powerful" also means that it needs to be adjusted in a timely manner according to the actual situation of economic operations, and fully leverage the dual role of structural monetary policy in adjusting the total amount and structure.