Crossing Letters

No. 002 · June 7, 2026

The dial is a useful picture, and it leaves out most of the machine. Here is how a modern central bank sets and transmits interest rates, with China as the worked example, and the data behind each figure.

Most people carry one picture of how interest rates work: a central bank, a dial, and rates across the economy moving when it turns. The real machinery has several parts, and they sit between the central bank and the rate you actually pay.

China is a useful place to watch this. Over the past few years it rebuilt that machinery in public, step by step, and published the reasoning as it went. So we can use it to see how rate-setting works more broadly.

Setting Rates

What “setting rates” actually means

A central bank has two kinds of lever. One is price: the rate it charges when it lends to banks, or pays when it holds their money. The other is quantity: how much cash and reserves sit in the system at all. A policy rate is the price lever at the very short end, usually overnight or a few days. What a household or a firm pays sits downstream of it.

So the central bank’s real task has three parts. Pick a short-term anchor. Keep market rates close to that anchor. And rely on the banking system to carry the signal out to real loans. Each part can work well or work badly, and the gap between them is where the interesting questions live.

The Anchor

Step one: China picks its anchor

For years, China leaned on the quantity side. The headline target was the growth of broad money, M2, and the reference rate sat in the middle of the curve, the medium-term lending facility, or MLF.

Between 2021 and 2025 the PBOC moved to a price-based framework built around the seven-day reverse repo rate, and designated it the primary policy rate in July 2024. The implementation reports set out three documented reasons.

First, the link between money growth and real activity had weakened. In 2024 the narrow money measure, M1, recorded negative year-on-year growth for several months while M2 kept expanding, so the aggregate was a weaker guide. Broad money has continued to expand each year across the period, reaching RMB 340.3 trillion by end-2025.

Second, the older chain from the MLF rate to the loan benchmark to actual lending was slow. In 2024 the PBOC moved the MLF operation to a window after the monthly benchmark fixing, and in March 2025 it changed the auction format to a multi-price tender, fading the MLF out as the fixed anchor. Third, a short-term policy rate lines China up with how the Federal Reserve, the Bank of England, and the European Central Bank operate.

The Corridor

Step two: the corridor that holds the rate in place

Naming an anchor is one thing. Keeping market rates near it is another, and this is the part the dial picture leaves out. Central banks build a corridor. The ceiling is a rate at which banks can borrow from the central bank on demand, so the market has little reason to pay more. The floor is what banks earn on idle reserves, so they have little reason to lend for less. Market rates trade inside the band, and the policy rate sits in between.

In China at end-2025 the ceiling was the overnight standing lending facility at 2.25 percent, and the floor was the excess reserve rate at 0.35 percent, a band of 190 basis points, with the seven-day reverse repo inside it at 1.40 percent. The PBOC has signalled it wants a tighter band. In 2024 it created temporary overnight tools priced at the seven-day rate plus 50 and minus 20 basis points, which would imply a corridor of about 70 basis points. A narrower corridor means firmer control of the short rate.

Transmission

Step three: from the policy rate to the rate you pay

A short rate means little to a borrower until it reaches loan pricing. China’s bridge is the Loan Prime Rate, or LPR, quoted by a panel of banks and used to price loans across the economy. At end-2025 the one-year LPR sat at 3.00 percent and the five-year, the reference for mortgages, at 3.50 percent, held for eleven straight months after a cut in May 2025.

The test of any transmission system is whether real borrowing costs follow. Across 2025, new corporate loans were extended at a weighted average of 3.22 percent, down 41 basis points on the year. That pass-through, from the policy rate through the benchmark to the actual loan, is the purpose of the plumbing.

Structural Tools

Step four: the part that is distinctive

Here the textbook model and China’s machinery move apart. The textbook central bank sets one price of money and lets the market decide where the credit goes. The PBOC runs a second track alongside the policy rate. It lends to banks at preferential rates, against loans to categories named in policy.

Agriculture and small-business re-lending have been in place for years. Technology-innovation re-lending and carbon-reduction support were added as the agenda shifted. Capital-markets facilities arrived in late 2024, and consumption and pension facilities in May 2025.

The reserve requirement ratio works on the same quantity logic. Between 2020 and 2025 the PBOC executed twelve cuts, lowering the weighted average by about four percentage points, and the cuts were tiered to favour smaller banks and inclusive-finance lending.

So the central bank steers the level of credit and its direction at the same time.

The Whole Stack

The concept, put back together

Step back, and China makes a general lesson visible. A central bank does not work one dial. It picks a short-term anchor, builds a corridor to hold market rates near it, leans on a benchmark to carry that signal into loans, and uses quantity tools for the rest. China layers a directional track on top of all of it.

So reading a rate decision means reading the whole stack. The policy rate gives you the signal. The corridor tells you how tightly that signal is held. The LPR tells you whether it reaches borrowers. And the structural tools tell you where the credit is meant to flow. The headline number is one piece of that picture.

In the handbook: Chapter 2 (Money Markets and the RMB) sets out the policy-rate framework, the corridor, LPR transmission, and the structural tools in full, with each figure traced to a primary source.

This piece maps Chapter 2 of Inside China’s Financial Markets (2026 Edition). The full book covers the system regulator by regulator, across twelve chapters. See the book.