Reviewing the Monetary Policy Transmission Mechanism

Monetary Policy includes the various set of policies initiated by the Central Bank to try to stimulate or slow the economy while trying to achieve their dual mandate of full employment and price stability. This typically includes changing interest rates, altering the size of the Central Bank balance sheet and communicating via “open mouth policy”. The transmission mechanism of these policies are controversial  and the goal of this post is to add some clarity to the ways in which this works.

Monetary Policy works through many different channels. This includes:

1. The interest rate channel
2. The financial crisis channel
3. The portfolio rebalancing channel (asset price effects, wealth effects & balance sheet channels)
4. The expectations channel
5. The credit channel
6. The exchange rate channel.

There’s considerable debate about the efficacy of each of these so let’s discuss each one a bit more.

The Interest Rate Channel. This is the most traditional form of the monetary policy transmission mechanism and is very widely supported by academic and historical evidence. This includes the Central Bank altering interest rates to try to influence consumption and investment. Since overnight interest rates serve as the benchmark interest rate across the economy the Central Bank can influence the cost of money which can alter interest rates across the entire interest rate structure.

The efficacy of this mechanism has come under debate more recently as higher interest rates had uneven and lagging effects during the housing bubble and 0% interest rates failed to substantially boost the economy during the recovery from the financial crisis. Further, there is considerable debate regarding the degree to which interest rates are the tail wagging the inflation dog. That is, do interest rates lead the economy or does the Central Bank simply set rates in response to other more important factors leading to a coincident impact across the economy? This can be different in different environments and in different economies.

I would argue the the interest rate channel has varying degrees of efficacy depending on the environment. For instance, there is substantial evidence that the high rates in the late 1970s were an important catalyst in boosting money demand and reducing inflation. There is less evidence, however, that low rates are a powerful stimulus during a low inflation environment (Japan in the 90s and the USA/Europe post-GFC are common examples). This makes sense since the interest rate channel works primarily by influencing credit demand (making credit more or less expensive) and influencing the discount rate which impacts asset prices. In periods where credit demand is weak these mechanisms will tend to be less impactful. This can also be true in economies that don’t have large and developed credit markets.

The interest rate channel is also closely linked to the exchange rate channel (discussed later). Higher or lower interest rates in the USA can create more or less demand for dollars as emerging market and developed markets borrow heavily in the global reserve currency and are highly sensitive to exchange rate changes that can be linked to interest rate changes. There is considerable evidence that rising interest rates in the USD can lead to slowing growth in countries that are highly dependent on dollar borrowing.

The financial crisis channel is, in my opinion, the most impactful monetary policy tool, but it can also have diminishing rates of return. The Central Bank operates as a bank for banks and is an important element in maintaining a healthy payments system. When private sector banks panic the Central Bank can operate as a backstop to keep payments flowing even when private banks do not want to operate. They can shore up the banking system in many ways including overnight loans, balance sheet expansion and altering interest rates.

During the GFC loans to banks and QE1 were examples of this. These policies helped put a floor under the markets at a time when there was a great deal of uncertainty. This bolstered asset prices, improved balance sheets and helped the economy stabilize. On the other hand, the impact of this declined as confidence was restored. Monetary policy works wonders in a crisis because the Central Bank is little more than a publicly supported clearinghouse that can help to substantially stabilize a banking system that is at risk of causing a broader crisis outside of the banking system.

The most popular view about QE is that it is just a way to manipulate asset prices via the asset price channel. While QE has clearly had an enormous psychological impact on the economy’s participants it’s almost impossible to quantify this impact. But we know that QE isn’t the only reason for rising asset prices. After all, with corporate profits near all-time highs it’s totally reasonable to assume that stocks have had a very solid fundamental underpinning over the last 5 years. You can see my more thorough explanation here.

Further, there is relatively little out of sample evidence to support the asset price and portfolio rebalancing mechanism relating to QE. While intuitive, there have been cases such as the EMU where QE and monetary policy has been much more aggressive than in the USA and yet asset prices have remained far more subdued.

One item of particular interest is research in the wealth effect relative to housing. Shiller, et al found have found that the wealth effect in housing can have a meaningful impact on consumer spending. This makes sense since houses are often used as collateral for both investment and consumption.

The expectations channel is widely touted in academic circles, but there’s less evidence that this has a substantial impact on the economy.  After all, the most popular view following QE1 was that high inflation and hyperinflation would ensue as a result of all that “money printing”, but we never saw a sustained pick-up in inflation. We saw a brief blip in commodity prices and reports of farmers hoarding commodities waiting for the inflation to come, but it didn’t last and the high inflation view has been soundly debunked by now. QE clearly doesn’t create high inflation and many academics are now wondering if the program isn’t actually deflationary.

One element of the expectations channel includes “open mouth” policy and the way in which the Central Bank can alter future expectations of policy by communicating their future policies. This can help set better expectations so markets and consumers can prepare for potential policy changes. This is why it sometimes appears as though Fed policy lags more than it really does – they have already communicated the future policy idea to markets in advance.

The credit channel is often cited as one powerful way for the Central Bank to expand the broad money supply. While the Central Bank can directly alter the quantity of money in many ways (such as making loans or altering the composition of private assets via Quantitative Easing) the Central Bank’s control of the money supply is best thought of as being somewhat indirect and many of their policies are attempts to change the future demand for money by influencing access to credit.

Importantly, this does not operate thru the “Money Multiplier” model that many of us learned in school. For example, it’s been widely believed that more bank reserve balances would lead to more bank lending in some money multiplier fashion. I still read, on a near daily basis, how banks aren’t “lending out” their reserves. Paul Krugman said it just the other day  and we’ve seen this view expressed by some of the most prominent economists in the world over the years. Of course, banks don’t lend reserves.  The money multiplier is a myth. And banking is primarily a demand side business. Well capitalized banks don’t run out of the ability to type new loans into their computers.  But they do run out of creditworthy borrowers in an economic environment where consumers are excessively indebted. This is why negative interest rates are failing in Europe and also why QE never led to a huge lending boom. Demand for debt has been weak.

On the other hand, raising interest rates can have a material impact on banks and the demand for credit by making credit less available to consumers, businesses and other banks. When the Central Bank increases interest rates this can directly impact the cost of funding for banks and typically leads to an increase in lending standards. If banks are unable to pass on their higher cost of funding to consumers then they can experience a slowdown in credit expansion. Likewise, higher interest rates can force consumers to spend more of their income on interest expenses which can pressure consumer balance sheets and make it more difficult to access credit in the future.

The exchange rate channel includes specific policies that impact the exchange rate and demand for that currency. This is often related to the interest rate channel as relative rates can alter relative currency demand, but this mechanism is most often used in emerging market economies that are not sovereign. These Central Banks can obtain foreign currency reserves thru trade and directly intervene in their own foreign exchange market to “manipulate” or target a specific exchange rate which can help induce demand they might not otherwise experience.

This can vary greatly across different countries, however. For instance, in Japan where the country is a significant exporter the exchange rate can make a meaningful impact on the economy. Much of the recent success of QE in Japan has been due to the exchange rate channel. The US Central Bank, on the other hand, has not been targeting the exchange rate so there’s been no meaningful impact from currency devaluation. China has also very successfully targeted their exchange rate with meaningful evidence to support a powerful transmission mechanism.

Of course, there are varying degrees of sovereignty across certain Central Banks. The US Central Bank is constrained in many ways that other Central Banks are not. This limits the power of the transmission mechanism. Further, as I’ve often noted, the monetary policy transmission mechanism is best viewed in coordination with fiscal policy. For instance, QE with a very large government deficit is an entirely different (and much more powerful program) than QE with a government surplus.

How Well Does All of This Work? 

There is robust evidence that changing interest rates has a material impact on credit markets, exchange rates and asset prices. But there is an asymmetry to the way this works. For instance, raising rates quickly tends to reduce credit expansion and asset prices materially whereas reducing interest rates tends to have more mixed results. This could be largely explained by specific environments and the demand for credit in such environments. For instance, in the last 10 years the demand for credit was low because households were overly indebted so reducing interest rates couldn’t bolster lending as much as many hoped.

As for QE the evidence is even more mixed. We’ve long argued that this form of “asset swapping” is just changing one safe asset into a similarly safe asset. There’s some evidence that this has a marginal impact on long-term interest rates, but the broader impact is mixed. So there’s little reason to expect such a policy to be highly stimulative, which is not to say it is not stimulative at all. But this also depends on the environment. For instance, QE1 bolstered bank balance sheets and asset prices materially due to the uniqueness of the environment. This had a positive impact on the broader economy, but later iterations of this policy likely had diminishing returns as the economy and markets normalized.

As for payment clearing and lender of last resort operations – we would argue that those policies work extremely well. The Fed can recapitalize and bolster any bank it wants. It is good at supporting the banking system and helping to operate the payment system. And they don’t get enough credit for how well this actually works. In fact, 2008 was a clear example of the Fed working well for the exact reasons it was created – to keep the payment system operating during a bank panic.

In short, the Fed’s operations are highly complex and the transmission mechanism has different impacts in different environments. Which explains why it continues to be such a controversial entity.

Sources:

¹ – The Monetary Transmission Mechanism – NY Fed

² – Symposium on the Monetary Transmission Mechanism. Journal of
Economic Perspectives – FS Mishkin

Some related work:

• Understanding the Modern Monetary System
• Your Textbooks Lied to you – the Money Multiplier is a Myth
• Understanding Quantitative Easing