One of the fundamental economic theories of economics is that changes in real interest rates should have an impact on output. There are several channels through which monetary policy is expected to impact the overall economy. As noted by the Austrian central bank, through the interest rate channel “a raise in key interest rates triggers an increase in short-term market rates. As a result, both the real interest rate and the cost of capital rise, putting a brake on investment.” The Bank of Canada also notes:
The main transmission channel is the effect that changes in the Bank’s policy rate have on various commercial interest rates, e.g., for mortgages, for consumer loans, as well as for deposits at financial institutions. A decline in commercial interest rates reduces both the cost of borrowing and the money paid on interest-bearing deposits, which tends to encourage borrowing, spending and investing, and to discourage saving.
–Bank of Canada
In the US, it is supposed to work much the same way. At a fundamental level, the Federal Reserve has many explanations of how monetary policy works to impact employment and inflation. The mechanics of this are to utilize changes in the Fed’s familiar policy instruments as explained by the St. Louis Fed for one basic example and San Francisco for another more detailed story. The New York Fed–who actually conducts the open market operations–explains what happens in the greatest and probably most accurate detail. However, the traditional story does not seem to work well when the central bank’s balance sheet is where it is now. There have been many stories about what the Fed needs to do in order to “normalize” monetary policy after the crisis, but they do not seem to be in much of a rush to get to this point.
Furthermore, Federal Reserve economists Steven A. Sharpe and Gustavo A. Suarez have recently put together a report that shows many firms are not particularly sensitive to changes in interest rates. As noted in their abstract:
A fundamental tenet of investment theory and the traditional theory of monetary policy transmission is that investment expenditures by businesses are negatively affected by interest rates. Yet, a large body of empirical research offer mixed evidence, at best, for a substantial interest-rate effect on investment. In this paper, we examine the sensitivity of investment plans to interest rates using a set of special questions asked of CFOs in the Global Business Outlook Survey conducted in the third quarter of 2012. Among the more than 500 responses to the special questions, we find that most firms claim to be quite insensitive to decreases in interest rates, and only mildly more responsive to interest rate increases. Most CFOs cited ample cash or the low level of interest rates, as explanations for their own insensitivity. We also find that sensitivity to interest rate changes tends to be lower among firms that do not report being concerned about working capital management as well as those that do not expect to borrow over the coming year. Perhaps more surprisingly, we find that investment is also less interest sensitive among firms expecting greater revenue growth. These findings seem to be corroborated by a cursory meta-analysis of average hurdle rates drawn from firm-level surveys at different times over the past 30 years, which exhibit no apparent relation to market interest rates.
–Steven A. Sharpe and Gustavo A. Suarez
So, while there are other channels through which monetary policy works this fundamental one seems to be ineffective in the last couple of years. The “portfolio balance channel” is another which is expected to help improve economic conditions through changes in the quantity of existing reserves. Quantitative easing in particular, is expected to have different effects when the central bank is facing the “zero-lower bound” on policy rates. Fed economists Fawley and Neely examine these channels in more detail. Finally, Ben Bernanke himself authored several papers explaining how the “financial accelerator” channel would work during a period of interest rates at the zero-lower bound.
Questions you might answer:
- Can the central bank affect the overall economy through the interest rate channel? How large is this effect expected to be? What do the authors above have to say about the effectiveness of monetary policy over the last several years? You do not have to read all these papers, but choose one or two to try gain some deeper insight about policy. You may also choose to some related news articles.
- If the Fed is poised to raise rates, and there is no impact on overall investment, how can the central bank impact demand in a way that avoids accelerating inflation?
- If the Fed is poised to raise rates, and that negatively impacts investment, then why do stock markets positively react to this? Wouldn’t the subsequent fall in investment lead investors to think that the overall value of the stock market would fall in the future? Think about what the Fed is saying about the current state of the economy if they are saying that it is OK to raise rates.