Unit 5 Macroeconomic policy: Inflation and unemployment
5.13 Transmission of monetary policy decisions to inflation: Domestic channels
Monetary policy relies on:
- the central bank being able to control interest rates
- changes in policy interest rates influencing market interest rates, which affect aggregate demand and, in turn, inflation.
How is monetary policy transmitted to the economy in practice? We will show that there are several channels, in addition to business investment and housing, including mechanisms acting through asset prices, and also the exchange rate.
The Bank of England publishes a diagram like Figure 5.18 to explain to the general public how it views the transmission of monetary policy from its policy interest rate decision to aggregate demand and inflation in ‘normal’ situations—that is, when the interest rate is its policy instrument. Other inflation targeting central banks publish similar diagrams.
Figure 5.18 Policy interest rate and monetary policy transmission mechanisms.
In this section, we examine the components of the diagram that relate to the domestic economy; the exchange rate channel is covered in the following section.
Market interest rates
In Unit 6 (page 000), we explain how the central bank can exercise this control.
When the central bank sets the policy rate, it effectively also controls the rate on all risk-free borrowing over relatively short periods—typically up to around three months.
For a wider range of market interest rates, the impact of changes in the policy rate is more indirect and, as Figure 5.19 illustrates for the United States, market interest rates may respond in a relatively limited way to policy rate changes; they will also respond to other factors.
Figure 5.19 The nominal policy rate and market interest rates in the United States.
Federal funds effective rates. FRED Economic Data.
To understand these relationships in the data, we need to think about the nature of the markets for lending and borrowing.
- bond
- A financial asset where the government (or a company) borrows for a set period of time and promises to make regular fixed payments to the lender (and to return the money when the period is at an end).
As explained in more detail in Unit 6 (page 000), commercial banks are profit-maximizing firms. They will usually respond to changes in the policy rate by adjusting the rates at which they lend to households (both consumer lending and rates on mortgages for house purchase) and firms. These rates will typically be above the policy interest rate: this feature is clearly visible in the chart. Just as for other price-setting firms, the extent of competition among banks will affect the size of the markup or spread of the lending rate above the policy rate. But we shall learn in Unit 6 that these rates will also be influenced—sometimes quite strongly—by the extent to which there is a risk of default (that is, of bank loans not being repaid), as well as the length of time over which funds are being lent. Both these effects are shown in the movements of the 30-year mortgage rate in Figure 5.19.
Similar factors affect the interest rates at which companies can borrow. In Unit 6 (page 000) we shall also learn that in many economies—especially in the United States and the UK—larger companies borrow large amounts by selling bonds rather than via loans from a bank. These are typically promises to repay the lender over quite long periods, from 5 to 30 years. The longer-term borrowing rates on such loans will usually respond to changes in the policy rate, but, as Figure 5.19 shows, often this response will be quite muted, since those buying the bonds will also take into account what the policy rate is expected to be, often multiple years in the future.
The fact that mortgage lending in the United States is typically over long periods of up to 30 years helps to explain why the mortgage rates and the corporate borrowing rates often show very similar patterns in Figure 5.19.
Exercise 5.10 The disconnect between the policy rate and lending rates
- collateral
- An asset that a borrower pledges to a lender as a security for a loan. If the borrower is not able to make the loan payments as promised, the lender becomes the owner of the asset.
- During the global financial crisis of 2008 and the following years, Figure 5.19 shows that the policy rate in the US fell very sharply to close to zero, while mortgage rates and corporate borrowing rates were initially unchanged. In the light of the discussion above, what do you think explains this pattern? (Hint: think about the extent to which the two types of borrowers have collateral.)
- In many countries, mortgage lending contracts have interest rates that are fixed for much shorter periods than in the United States, or may simply be ‘floating rates’ that can be changed at short notice by the lender. How would you expect this to affect the relationship between mortgage rates and the policy rate? Find some data to test whether your expectations were correct.
- The chart below shows that the rate on credit card debt is always significantly higher than the policy rate, and relatively unresponsive to changes in the policy rate. What features does such borrowing have in common with mortgage lending and lending to corporations, and what features are distinct?
Figure for Question 3 The disconnect between the policy rate and lending rates.
Commercial Bank interest rates on credit cards. FRED Economic Data.
The impact on domestic aggregate demand
The Bank of England diagram in Figure 5.18 highlights two channels from a change in the policy rate to aggregate demand. One of them operates via the exchange rate and net exports, and is explained in the next section. Here, we focus just on the linkages with the domestic components of aggregate demand: the impact on investment and consumer spending.
We would not in general expect government consumption spending (G) to be sensitive to the interest rate.
Investment
As the present value model shows, firms’ investment decisions depend on interest rates and expected future profits. If a rise in the policy rate causes the real interest rate to rise, then ceteris paribus, firms will reduce their investment spending.
In practice, however, it is found that business investment is not very sensitive to the real interest rate. The explanations relate to the fact that when the interest rate changes, other factors do not remain constant. In other words, the ceteris paribus assumption does not hold. For example, if the policy rate is being cut because the economy is in a recession, we might well expect—on theoretical grounds—that risk premiums might simultaneously be rising: investment projects are judged to be more risky. This would offset the effect of the fall in the interest rate and leave the discount rate relatively unchanged, thereby limiting the effect of the policy decision on investment. In a recession, it is also possible that the expected rate of profit on new investment projects would fall, again hindering a strong response of investment to a fall in the policy rate.
On the other hand, there is good evidence that changes in real interest rates have a substantial effect on investment in housing, which is part of fixed capital formation. However, different systems of housing finance in different countries affect the interest-sensitivity of investment in housing.
The other component of investment, government investment—such as on infrastructure—is typically much less responsive to real interest rates.
Asset prices and consumer expenditure
- asset prices
- Asset prices is a general term used to refer to the prices of both financial assets (like shares or bonds) and real assets (such as housing, land, gold, or works of art). See also: asset.
We know from the previous section that changes in interest rates also affect asset prices. These include not only financial assets, but also house prices: buying a house is a form of investment—you incur the cost immediately, and expect to receive benefits in the future. When market interest rates go down, asset prices will typically go up. This in turn can be expected to feed through to aggregate demand, particularly by households (c0 in the consumption equation), because those households that own the assets will feel wealthier.
In a similar way, interest rates will affect spending by households on consumer durables, and also residential investment—a substantial component of which is made up of improvements to existing houses. Here, we would expect there to be both a direct channel from interest rates, via the cost of borrowing, and an indirect channel via asset prices, particularly house prices.
Expectations and confidence
We have stressed the importance of profit expectations and confidence for the investment decisions of firms. When setting the policy rate, the central bank tries to build confidence through consistent policymaking and good communication with the public. If it lowers the policy rate in the context of a negative shock to aggregate demand, for example, and explains its reasoning, this can lead firms to expect higher demand, which will lead to higher investment. Similarly, if it increases the confidence of households that they will not lose their jobs, then they may feel more comfortable in sustaining their regular spending. The confidence channel can help shift the economy from the low-investment equilibrium illustrated in the coordination game in Figure E3.3 to a high-investment equilibrium.
Real versus nominal interest rates
As we stressed in Section 5.2, economic theory would predict that it is the real interest rate that affects spending. But when the central bank sets the policy rate, it sets it in nominal terms. So by setting a particular nominal rate, it is aiming for a specific real interest rate—and it therefore needs to take into account the effect of expected inflation, using the Fisher equation, on the range of market interest rates affected by its policy change.
Read, for example, ‘Nominal Interest Rate Effects on Real Consumer Expenditure’ by James A. Wilcox for the empirical evidence.
Interestingly, there is evidence that changes in real and nominal interest rates can affect spending. While standard economic reasoning would suggest only real interest rates should matter, changes in nominal interest rates can significantly affect household disposable income, especially via mortgage interest payments. If, as discussed in Unit 3, households are subject to credit constraints, a rise in nominal interest rates can reduce consumer spending, even when real interest rates do not change. Empirical evidence suggests that this channel for interest rate changes can sometimes be quite powerful.
And last (but not least): The impact on inflation
As we have stressed, the central bank’s primary remit is to control inflation. Therefore, there is a further crucial link in the transmission mechanism of monetary policy: the link between demand and inflation. The central bank will be relying on the operation of the Phillips curve that links the level of output and demand to the inflation rate. This linkage has been very powerful at times (as illustrated in Figure 5.13); but it is also far from straightforward, in particular given the role of inflation expectations.
The next section shows that, to the extent that changes in monetary policy affect the exchange rate, this will not only considerably strengthen the impact on aggregate demand (via net exports) but also, crucially, will have a direct impact on inflation—as highlighted in the Bank of England’s diagram.
To follow the transmission of monetary policy from the policy rate to inflation, work through Figure 5.20.
Figure 5.20 The transmission of monetary policy from the policy rate to inflation.
Market interest rates
Elements of the business cycle model
Asset prices and expectations
Exchange rate and net exports
Import prices
The transmission mechanisms
