The long shadow of monetary policy
A long tradition of macroeconomic analysis accords monetary policy only a transient role in driving real outcomes. Under ‘money neutrality’, the monetary policy regime has no influence on the equilibrium paths of any real variable. Hence the widespread view that real interest rates are tied to some ‘natural rate of interest’ whose variations are dictated purely by real saving-investment drivers (Bean 2015). Current discussion of what the post-Covid policy landscape could look like is based on that worldview (Goy and van den End 2020). At the same time, a large body of evidence highlights the persistent economic impact of financial cycles, particularly those that end in crises, on economic activity (BCBS 2016, Claessens et al. 2012). This begs the question: to the extent that monetary policy has a material influence on the financial cycle, could it also have long-lasting effects on the path of real variables?
In a recent paper (Rungcharoenkitkul et al. 2019), we present a theoretical framework where the answer to this question is yes. In the setup, credit supply frictions imply that low interest rates boost risk-taking, thereby generating financial fragility. Financial fragility, in turn, leads to sizeable and persistent output losses when stress materialises. As a result, monetary policy is key in determining the economy’s vulnerability to boom-bust cycles, its long-run evolution, and hence also that of the (equilibrium) real interest rate. For the central bank, this creates path dependency, i.e. future policy depends on constraints determined by current policy. This gives rise to an intertemporal policy trade-off: easier policy today boosts output in the short run but at the expense of a build-up of financial imbalances and large output losses down the road, which then in turn constrain the central bank’s room for policy manoeuvre.
Generating a persistent impact of monetary policy requires linking it to some fundamental features of the economy. One approach is to link demand shortfalls to the economy’s supply side, such as through scarring effects on labour and capital (Reifschneider et al. 2015) or on innovation (Benigno and Fornaro 2018). We take a different tack and focus on the economy’s proclivity for financial boom-bust cycles in a setting where multiple equilibria are possible and monetary policy pins down a particular path for the economy through the cost of financing.
The model revolves around two key building blocks.
- The first, which generates long-run non-neutrality, is the primacy of financing – cash flows – in underpinning economic activity. The model features true ‘monetary exchange’, whereby banks play a critical role in the economy by providing the financing which firms need to produce. Critically, by granting loans, banks generate out of thin air the purchasing power (deposits or inside money) necessary to purchase goods and repay loans. This realistic feature contrasts with the typical ‘real exchange’ approach, which assumes that banks simply intermediate real resources among agents but do not create purchasing power. As a result, and critically, banks’ elastic supply of financing allows aggregate demand and supply to be matched at any interest rate level; there is no single real interest rate – the natural rate – that balances real saving and investment, thereby ensuring goods market equilibrium. It is up to the central bank to anchor the level of the interest rate, and hence the levels of bank financing and output.
- The second building block consists of lending ‘frictions’ that give rise to a financial cycle. Here, we make some assumptions that replicate the pattern of aggressive lending and retrenchment seen in reality. In competing for market share, banks inadvertently take on excessive risk when interest rates are low. Ensuing losses then deplete bank capital to a point where the risk of bankruptcy is so high that banks revert to a conservative strategy, charging higher rates and rebuilding capital. The loan market is thus subject to multiple equilibria – exhibiting phases of excessive risk-taking (booms) followed by periods of risk aversion (busts).
These features raise the possibility that the economy, including real interest rates, does not converge to a fixed steady state, but alternates between boom and bust phases. Because interest rates influence risk-taking, the nature of these fluctuations depends on the central bank’s reaction function, as monetary policy sets banks’ funding costs and can thereby mitigate lending frictions. The monetary regime is an integral part of the economy’s equilibrium, as some empirical evidence appears to indicate (e.g. Borio et al. 2018).
The interaction between monetary policy and the financial cycle has a long-term impact on the economy and gives rise to an intertemporal trade-off. A higher policy rate today counteracts risk-taking and restrains the boom at the cost of more subdued growth in the short run. But this ‘leaning’ strategy promotes a more robust and better capitalised banking sector, which not only reduces the risk of a bust but also the economic damage should one occur.1
The outcome depends critically on how long the central bank’s policy horizon is. When the central bank is less forward-looking (i.e. it has a lower discount factor β), the economy is more vulnerable to booms and busts, and output is more volatile. More importantly, real interest rates are lower on average in such a case – they are lower during the boom as the central bank leans little, and low for longer during the bust as the financial cycle is more virulent.
Figure 1 illustrates this stylised pattern. The policy rate, bank capital, the regime, and output are shown in blue and red for, respectively, the more forward-looking (β = 0.95) and less forward- looking (β = 0.85) central bank. In the former case, the policy rate is on average higher (top left-hand panel), bank capital (top right-hand panel) and output (bottom right-hand panel) are less volatile, and the boom-bust cycles less frequent (bottom left-hand panel). In fact, given the specific calibration, there is only one such cycle if the central bank is more forward-looking, with the economy spending most of the time in the boom phase.
Figure 1 Monetary policy and boom-bust cycles
Notes: Dynamic simulation under optimal monetary policy when the central bank’s discount rate is β = 0.95 and β = 0.80. Both simulations are based on the same sequence of shocks that determine regime switches.
Furthermore, introducing some policy inertia highlights an insidious form of monetary hysteresis. In Figure 2, we add the assumption that the central bank cannot adjust the otherwise optimal policy rate by more than a fixed amount each period – a standard ‘gradualism constraint’ (e.g. Coibion and Gorodnichenko 2012). Starting in a boom, policy first leans against the financial upswing and then eases to support the economy once a bust ensues. As the economy recovers and enters a boom again, the central bank starts to tighten, but this time inertia keeps the interest rate lower than what is necessary to rein in the boom. As a result, the next bust occurs sooner, which forces another round of rate cuts. This ratcheting process continues to push the interest rate down over successive cycles, with busts becoming more frequent and booms shorter-lived. The central bank in effect falls into a kind of ‘low interest rate trap’ – an increasingly potent financial cycle and a downward trend in the interest rate reinforce each other. In this sense, low rates beget lower rates.
Figure 2 Low rates begets lower rates
Note: Dynamic simulation when the central bank targets the optimal policy rate but can only adjust it gradually each period.
Authors’ note: The views expressed are those of the authors and do not necessarily represent those of the Bank for International Settlements.
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Benigno, G and L Fornaro (2018), “Stagnation traps”, Review of Economic Studies 85(3): 1425–70.
Borio, C, P Disyatat, M Juselius and P Rungcharoenkitkul (2018), ”The ‘real’ illusion: how monetary factors matter in low-for-long rates”, VoxEU.org, 18 October.
Claessens, S, A Kose and M Terrones (2012), “How do business and financial cycles interact?”, Journal of International Economics 87(1): 178–90.
Coibion, O and Y Gorodnichenko (2012), “Why are target interest rate changes so persistent?”, American Economic Journal: Macroeconomics 4(4): 126–62.
Goy, G and J W van den End (2020), “The impact of the COVID-19 crisis on the equilibrium interest rate”, VoxEU.org, 20 April.
Reifschneider, D, W Wascher and D Wilcox (2015), “Aggregate supply in the United States: recent developments and implications for the conduct of monetary policy”, IMF Economic Review 63: 71–109.
Rungcharoenkitkul, P, C Borio and P Disyatat (2019), “Monetary policy hysteresis and the financial cycle”, BIS Working Papers No. 817, October.
1 Moreover, as empirical evidence indicates, financial cycles may have persistent first-order effects on the misallocation of resources and hence productivity. Such considerations, ignored in our analysis, would strengthen the conclusion concerning the long-term impact of monetary policy.