London, 14 February 2010

China's decision to raise bank reserve requirements has jolted markets for oil and other industrial commodities, confirming that prices are now more closely tied to growth and monetary policy in emerging markets than the advanced economies. In future, commodity markets are more likely to look to the People's Bank of China (PBOC) than the Fed for a sense of direction.

The shift in focus is hardly surprising. It reflects the shifting centre of gravity in global manufacturing. The International Energy Agency (IEA) and other commentators admit oil demand has already peaked in the advanced economies.

Consumption growth now comes entirely from emerging economies in China, the rest of Asia and the Middle East. The same is true for iron ore, steel and base metals such as aluminium, copper and zinc. Some commentators continue to suggest the main transmission mechanism by which China's monetary policy impacts on commodity prices is via the dollar. But the real impact is via demand. With China and other emerging economies providing all the marginal demand growth, commodity prices will become increasingly sensitive to shifts monetary policy in Asia rather than North America and Western Europe.

A Range of Instruments

Historically, central banks employed a range of levers to affect both the price and the quantity of credit across the whole spectrum of maturities. In the last four decades, though, western central banks abandoned most of these instruments to focus on implementing policy by adjusting a single short-term interest rate. Rates at longer maturities and the total volume of credit have been left to the market to determine.

Surrendering so many instruments was a mistake. This rather narrow approach proved incapable of restraining either the pre-crisis boom in bank lending or averting the subsequent collapse when the financial bubble burst.

The crisis has forced a profound rethink. Western central banks have rediscovered the merits of a more sophisticated strategy that includes managing banks' reserves, as well as manipulating the price of longer-dated securities through open market operations (OMO) and market-making liquidity programmes. Using the central bank's entire balance sheet to manage the cost and quantity of credit throughout the economy has suddenly become fashionable.

China's central bank is trendily old-fashioned in this respect. It has continued to employ a whole range of instruments to implement monetary policy -- including reserve requirements, rediscounting facilities and open market operations, as well as providing interest rates on loans and deposits at a whole spectrum of maturities. PBOC used all these instruments aggressively between 2006 and June 2008 to curb the boom, then reversed course with all of them to deal with the bust.

Broader Tightening Signal

Reserve requirements are only one element in PBOC's monetary arsenal. So far PBOC has not raised interest rates. Borrowing costs remain at the ultra-low level the central bank adopted to tackle the collapse in demand during H2 2008.

But changes in reserve requirements probably herald a broader shift in monetary conditions. Reserve requirements were the most frequently used weapon for tackling the inflation crisis in 2006-2008. They have usually been employed in tandem with rate changes throughout the curve.

The fact PBOC has now raised required reserves twice in two months signals a decisive shift is under way. Interest rates will also rise in the months ahead. PBOC's objective is not necessarily to slow growth. It wants to end the ultra-accommodative policy used to tackle the crisis and replace it with a modestly restrictive stance to stop a bubble forming in the country's real estate and stock markets, as well as preventing overheating in the real economy.

But the tightening cycle will wash through global commodity markets and is likely to restrain further price increases in the next 6-12 months.

Ends --

By John Kemp, Reuters columnist. The views expressed are his own --