One of the fundamental economic theories of we discuss here is the role played by interest rates and their impact on output and inflation. There are several channels through which monetary policy is expected to impact the overall economy. Note, that usually when we talk about interest rates here, we mean “real interest rates” which means that we are dealing with a stable rate of inflation. 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 were many stories about what the Fed needed to do in order to “normalize” monetary policy after the financial crisis, but that has all been thrown into reverse with the COVID-19 pandemic (https://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm). It has been emergency procedures all over again from the Fed, as they have expanded their balance sheet and made many efforts to protect the financial system (https://www.brookings.edu/research/fed-response-to-covid19/).
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
Notably, the Fed has made additional efforts to broadcast future interest rates and the desire for higher inflation in the medium term. We might be willing to have slightly higher inflation to get our economy moving again, by letting it get a bit “hot” and push unemployment lower. These recent announcements are “huge” news, and potentially acknowledge that things like the Phillips Curve are not as powerful as once thought, that the natural rate of unemployment might be deeply flawed, and that ‘potential GDP’ is not the stable rock we like to think it is. The Fed has responded by saying they may keep rates near zero for several years, undercutting the argument by some that this is a speedy recovery. They clearly believe the economy is weak, and will remain weak for the foreseeable future. Fiscal stimulus might change this, but the political will has not been there since the early days of the pandemic.
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 after the financial crisis and during the recent COVID-19 pandemic? 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 read some related news articles.
- If the Fed is poised to keep rates low for years, and there is no impact on overall long-term investment, how can the central bank impact demand in a way that gets inflation to accelerate as they would like to see happen?
- If the Fed is poised to keep rates low, but can’t lower them any further without going negative, how might that impact investment? Why doesn’t the Fed consider negative nominal interest rates? What are the arguments for or against that? Think about what the Fed is saying about the current state of the economy if they are saying that they will not raise rates for several years.