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Friday 14 February 2014

Identifying monetary policy cycles

Changes in monetary policy usually involve many small shifts in interest rates, because central bankers are increasingly reluctant to shock an economy by adjusting interest rates too drastically. Even the potential for large interest rate changes could contribute to uncertainty among investors and businesses, potentially disrupting or delaying well-laid business plans, harming the overall economy in the process. Typical interest rate changes among the major central banks center on 1/4 percent or 25 basis points (a basis point is 1/100th of 1 percent, or 0.01 percent), with 50 bps (or 1/2 percent) as the next most frequent rate adjustment.

In recent years, 50 bps adjustments have primarily been used in extreme situations, such as during the Asian financial crisis/Russian debt default/Long Term Capital Management (LTCM) collapse of 1998. Talk about a bad year. In early 2001, 50 bps rate changes were employed as the dot-com bubble burst and in the aftermath of 9/ 11 a bad year unlike any other. So unless-circumstances are extreme or urgent, or a central bank has fallen hopelessly behind economic events, 25 bps moves are the norm.

Adjustments to monetary policy and changes to interest rates usually play out over extended periods of time, ranging from quarters to years. In the first place, it takes time for central bank policy makers to accumulate sufficient economic data to make judgments about when and by how much interest rates need to be adjusted. There is also a time lag between when interest rates are changed and when they affect business or consumer behaviour. The time is usually estimated at 12 to 18 months but may be as long as 24 months.

The life of a monetary policy cycle

To give you a better understanding of how monetary policy cycles work, look at the following case, where an economy is emerging from a period of very low or negative growth over an extended period of time. We start from then low point of the interest rate cycle.

In response to the economic downturn, the central bank had lowered interest rates to a level it deemed “stimulative” or low enough to rejuvenate growth by stimulating borrowing and investing.  After many months in a low interest rate environment, and as incoming economic data reports point to expanding economic activity and growth rates, the central bank may decide to remove some of the policy stimulus by raising interest rates. This first interest rate hike following a series of cuts represents the beginning of a cycle of tighter monetary policy. The overall level of interest rates may still be considered “accommodative” in relative or historical terms but some of the accommodation has been removed. Assuming economic growth continues to build strength, the central will progressively hike rates further, removing remaining accommodation.

Somewhere along the way, the central bank will reached an equilibrium interest rate level representing a “neutral” monetary policy. In theory, a neutral monetary policy is one-in-which interest rates are neither stimulative nor restrictive. In real terms, though, it’s nearly impossible to pin down exactly what constitutes a neutral interest rate level. A neutral level of interest rates will change over time as an economy evolves - what may have been neutral in the last cycle is now considered restrictive. As a result, central bank officials and economists tend to talk about a range of interest rates that may represent policy neutrality - say, something like 5 percent to 5.5 percent.

If economic data indicates that growth is beginning to slow or decline, the central bank is likely to stop hiking rates and wait for a period to determine how the economy is responding. This interest rate outlook is frequently referred to as a neutral bias. It may be the peak in the current tightening cycle, or it may just be a brief pause - only time and the economic data will tell. Central banks also refer to this as a balanced outlook, meaning that the risks to growth and inflation are roughly even.

If growth picks up steam again, or if inflationary pressures become evident, the-central bank is likely to increase benchmark interest rates further, pushing monetary policy into a restrictive zone. From the growth side of the picture, a restrictive monetary policy seeks to restrain or slow economic growth by increasing the costs of borrowing. At the consumer level, higher interest rates begin to shift the incentives from borrowing and spending toward saving and investment, reducing personal consumption and contributing to slower economic growth.

This cycle continues until the economy weakens sufficiently or inflationary pressures subside enough or some combination of both, to cause monetary policy to reverse direction. And the potential scenarios are many. Growth could slow, but inflation could remain elevated. Growth could level off, and inflation could fade. Growth could accelerate along with inflation.

The specter of inflation

In terms of inflation, higher interest rates are a signal from the central bank to businesses and markets that further price increases are undesirable and will be met with higher interest rates. For better or worse, central bankers consider themselves the guardians of economic and price stability, and nothing is more alarming to them than inflation above tolerable levels, typically cited as about 2 percent to 3 percent annually. Given the inflation mandates of some central banks, interest rates may be forced ever higher by inflation, choking, off growth in the process and leading to a downturn in the economy.

Credibility is the watchword here. A central bank's credibility is based on markets’ perceptions of the central bank’s willingness to combat inflation, even if it means causing an economic downturn. This situation is the worst-case scenario for a central bank and essentially is what happened to the U.S. economy in the late 1970s and early 1980s. In the process, however, Fed Chairman Paul Volcker proved highly credible in his commitment to defeating inflation and set the stage for a more credible Fed policy under Alan Greenspan. The Fed’s enhanced credibility with markets paved the way for significant periods of growth in the ensuing decades, with only minor outbreaks of inflation that were quickly extinguished. 

Because monetary policy acts with a time lag, central banks need to be proactive and forward looking. Estimates from the Fed itself are that monetary policy changes carry a 12- to 18-month time lag. That means that rate changes made today may begin to affect the economy only in about a year’s time. By the time economic growth is considered strong enough to stoke inflation, for example, it may already be too late for a central bank to head off future price increases. Inflation may already be in the pipeline, and higher prices are looming. To get around this, central bankers rely on economic forecasts and models to guide their policy decisions.

But central bankers can hardly escape the day-to-day messages coming from current economic data and market signals. Sharp increases in the unemployment rate can generate tremors in the economy, sending consumer sentiment plunging. (Rising unemployment rates can increase feelings of job insecurity restraining personal spending.) On the flip side, declines in the unemployment rate can signal a shortage of labor, creating fears of wage-driven inflation. (As the labor force becomes tighter, workers are supposedly able to demand higher wages.) Each suggests a different monetary policy direction. Taken together, monetary policy decisions are based on both current data and expectations for growth and inflation.
 

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