The Reserve Bank’s bulletin series returns in the September quarter of 2017 with a back-to-basics review of the transmission mechanism of monetary policy. In ‘The Transmission of Monetary Policy: How Does It Work?’, Tim Atkin and Gianni La Cava bifurcate the transmission mechanism into two stages, the first being a concentrated impact on interest rates, the second being the wide-ranging spill-over impacts on economic activity and inflation. Their core insight is that the housing market is responsible for propagating activity through the economy: it is where the transmission mechanism is at work. Atkin’s and La Cava’s analysis, however, would be improved if a consideration of the breakdown of the transmission mechanism was included in the light of what Larry Summers (2014) terms ‘secular stagnation’, a situation of high debt, low growth, low demand, low interest rates, and low inflation.
The objective of monetary policy consists in: the economic prosperity and welfare of Australians; full employment; and price stability. The goal of monetary policy is inflation targeting. The instrument of monetary policy is the cash rate. These three pillars of monetary policy, argue Atkin and La Cava, are best illuminated by the transmission mechanisms system (p. 01). Their fundamental assumption is that the first ‘interest rates’ stage is followed by the second ‘economic activity and inflation’ stage sequentially, not simultaneously, as in select (varying coefficient Bayesian panel) vector autoregression (VAR) models, which make use of simultaneous mathematical determinations derived from linear algebra. Examining the first stage, the authors note that funding conditions, competition, and risks in financial markets primarily influence the effectiveness of ‘interest rate pass-through’ (p. 03) i.e. the cash rate’s effect on interest rates. A further distinction is made between the scope of ‘interest rate pass-through’ and its speed, the latter determined along fixed/variable lines. The central bank can choose to compensate for these impacts by opting, for example, ‘for a larger reduction in the cash rate as required to achieve the desired monetary policy setting’ (p. 04). From here the authors launch their appraisal of the second stage of monetary transmission.
There are four core channels, centred on savings and investment, cash flows, asset prices and wealth, and the exchange rate. Concomitantly, the authors make four key contributions: sensitivity of household consumption to changes in interest rates are difficult to establish; following from their core insight, mortgage-constrained households are substantively responsive to rate changes; wealth and balance sheet channels are difficult to disentangle because younger, financially-constrained households are sensitive to wealth effects; and exchange rate depreciations lead to ‘a large and immediate increase in import prices’ (p. 07), but their indirect cost-push effects (via higher-priced inputs) are harder to define.
Throughout, the authors emphasise the role of microeconomic constraints, in line with literature on Euler and time-horizon analyses that determine demand via an expectations-optimised IS-LM framework. Crucially, the authors stress that the saving-investment channel represented in these models should be differentiated from the (household) cash-flow channel, where their interest in constraints actually lie. Indeed, they question the saving-investment channel, uncertain whether ‘a strong relationship between lower interest rates and higher consumption growth actually exists’ (p. 05). Yet, notwithstanding, Atkin and La Cava’s core assumption concerning mortgage-holders stimulating activity as a result of higher disposable income has been questioned recently. Cloyne et al. (2016, p. 14, 32) found that indebted households responded to a 25-basis point fall with just 0.2% higher non-durables consumption.
A related issue arises when the authors argue that for all channels, a reduction in the cash rate should lead to lower interest rates, and therefore higher economic growth and inflation. Crucially, they posit that ‘the links between economic activity and inflation are basically the same for all channels’ (p. 04). That is to say, once a channel affects economic activity, the inflationary consequences follow necessarily, so as to be virtually independent of the channel. However, recent trends have challenged this assumption. Traditionally, these causes and effects hold given the mediatory role of the liquidity preference—money supply (LM) market. When rates fall, cash demand, and therefore consumption, rises. However, with the return of liquidity traps, where banks fail to forward on loanable funds from the central bank’s expansive balance sheets (Figure 1), these crucial mediatory functions break down. As a result, in Britain inflation has ensued, not following economic growth as expected (Charts 2.1/4.2, BoE 2018, p. 10, 26).
In explaining the complex and interconnected chains of causality that bind interest rates with economic activity and inflation, Atkin and La Cava show why today, perhaps more than at any other time, the transmission mechanisms of monetary policy are important to understand and study. They establish a crucial distinction between the saving-investment channel, and the (household) cash flow one. In the former, consumption is held to rise through inter-temporal substitution. However, in the cash flow channel, consumption is expected to rise because borrowers enjoy higher disposable income from reduced loan repayments. The emergence of ‘secular stagnation’, however, has dampened the response of households, and also businesses, with the spectre of a liquidity trap under chronically high debt. This has, for some countries, culminated in the startling breakdown of the link between economic growth and inflation.
Atkin, T. and La Cava, G. (2017), ‘The Transmission of Monetary Policy: How does it Work?’, Reserve Bank of Australia Bulletin (September Quarter), pp. 1-8, available at https://www.rba.gov.au/publications/bulletin/2017/sep/1.html
Bank of England (2018), Inflation Report: August 2018, published 02 August, London: Bank of England, available at https://www.bankofengland.co.uk/-/media/boe/files/inflation-report/2018/august/inflation-report-august-2018.pdf
Cloyne, J., Ferreira, C. and Surico, P. (2016), Monetary Policy When Households Have Debt: New Evidence on the Transmission Mechanism, working paper no. 589, published 08 April, London: Bank of England, available at https://www.bankofengland.co.uk/-/media/boe/files/working-paper/2016/monetary-policy-when-households-have-debt-new-evidence-on-the-transmission-mechanism.pdf?la=en&hash=F1C10A3548F50FF64D70369564633F94FF8DC400
Debelle, G. (2017), Business Investment in Australia’, In Speeches series, Speech to the UBS Australiasia Conference 2017, published 13 November, Sydney: Reserve Bank of Australia, available at https://www.rba.gov.au/speeches/2017/sp-dg-2017-11-13.html
Lowe, P. (2015), ‘Low Inflation in a World of Monetary Stimulus’, In Speeches series, Speech to the Goldman Sachs Annual Global Macro Economic Conference, published 05 March, Sydney: Reserve Bank of Australia, available at https://www.rba.gov.au/speeches/2015/sp-dg-2015-03-05.html
Summers, L.H. (2018), ‘Secular Stagnation and Macroeconomic Policy’, IMF Economic Review, vol. 66, no. 2, pp. 226-250.
Excellent short 5 minute introduction
More in-depth discussion
From Lawrence Summers, who coined secular stagnation