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.
