Is monetary policy exhausted?
Max Rowley-Sanchez
Over the year or so of Covid-19 the world has and is still undergoing one of the biggest periods of economic shock in modern history. Countries around the world have been plunged into economic turmoil with governments and central banks frantically using all the emergency measures at their disposal in a desperate attempt to achieve some form of economic stability. The severity of the economic shock has made many commentators question the effectiveness of traditional macro- economic policies, in particular monetary policy. Monetary policy is a policy adopted by the monetary authority of a country to control either the interest rate payable for short-term borrowing or the money supply. Most central banks have a single mandate – to achieve price stability – although some like the US Federal Reserve have a dual mandate incorporating employment or growth objectives in addition. 1 Traditional monetary policy consists of changes to the base rate of interest to control price stability. The impact that the change of the base rate has on the economy is described best by the monetary policy transmission mechanism. The change to the base rate as dictated by the central bank influences the interest set by commercial banks as the base rate is the interest charged by central banks to commercial banks when borrowing money. Commercial banks then pass on the borrowing costs to consumers who choose to borrow or else pay interest to customers choosing to save. Therefore, there’s a correlation between the base rate and commercial interest rate. In summary , the central banks’ ability to increase or decrease the base rate influences all other interest rates to consumers and corporates. However, the traditional monetary policy transmission mechanism does appear to have a rather long list of constraints, making some question its efficacy. The first major constraint is time lags. It can take 18-24 months for any changes in the base rate to be felt by the macro-economy due to the fact that the base rate is set to control the future inflation rate. This can only take effect if the base rate and interest rates are fully implemented by banks. The housing market since the global financial crisis has experienced a considerable decoupling between the base rate and mortgage rates. This can hinder the effectiveness of monetary policy considerably. Expansionary monetary policy is unlikely to boost aggregate demand as much as it otherwise could since housing is generally the single biggest asset acquisition a person makes. Further limitations to monetary policy include firms and consumers’ willingness to borrow. In times of economic uncertainty confidence tends to be low as people fear unemployment. This idea exists as far back as 1936 when Keynes coined the phrase ‘Animal Spirits’ 2 to describe the instincts and emotions that ostensibly influence and guide human behaviour. By virtue of this, consumers and firms become increasingly risk-adverse, and thereby their marginal propensity to save increases. 1 In 1963 when Milton Friedman and Anna Schwartz published their now famous research on the history of monetary policy in the US, they concluded that the overly restrictivemonetary policy pursued by the US Federal Reserve exacerbated the impact of the Great Depression. As a result, they concluded that ‘k - percent rule’ should be implemented by monetary authorities whereby the central bank should seek to annually expand the money supply by a pre-defined percentage. 2 Keynes, JM. (1936); The General Theory of Employment, Interest and Money.
206
Made with FlippingBook Digital Publishing Software