January 17, 2016


Impact of Monetary Policy


Contributor(s): Peter del Rio
Last Edited: 2016-09-27

September 17, 2016 The impact of monetary policy is dependent upon current interest rates. The applied equation that captures the monetary impact of an interest rate move, is the change in interest rates, Δ ir divided by current interest rates ir or (Δ ir / ir). The graph of the equation demonstrates that the impact of monetary policy is nonlinear and parabolic and most impactful at 0%. In short, at near-zero interest rates, a small move in monetary policy has a huge impact. Explained
The equation (Δ ir / ir) captures the multiplier effect of leverage on capital when interest rates approach 0%. It also demonstrates the near infinite amount of capital created by leverage at 0% evaporates very quickly as the central bank moves off of 0% - either positively or negatively. In short, the impact of a 5 basis point move near-zero is equivalent to a 25 basis point move when interest rates are at 1.25% and two times more impactful than when interest rates are at 3%.

Over the past 60 years, the US Federal Reserve’s Fed Funds rate has spent most of the time above 3% (See chart below). The equation also demonstrates that when interest rates are 3% or greater, the impact of monetary policy looks linear. So previously, without empirical evidence, it is understandable why many view the impact of monetary policy as linear and believe more than one tightening is necessary for monetary policy to be impactful.

Historical Perspective
Leading up to 1980, US inflation grew and interest rates rose as the price of oil grew 10 fold and the purchasing power of US consumers rose. The rising purchasing power of the US consumer came from women joining the workforce and the securitization of the mortgage market. During this period, this rising purchasing power competed for limited domestic products that drove inflation and interest rates to historic highs. Interest rates peaked in the early 80’s as the US economy began to open up globally. The period from 1984 to 2007 was driven by globalization, the increase in worker productivity and the refinancing of the mortgage market as interest rates went down to historic lows.

In 2008, in response to the global financial crisis, Federal Reserve Chairman Ben Bernanke lowered the Fed Funds rate to 0%. The Federal Reserve maintained the Fed Funds rate at 0% for over 7 years. The historically low level in the Fed Funds rate was meant to combat deflation while trying to achieve the Fed’s dual mandate of full employment and 2% inflation. During this time, US asset prices reached historic highs, inflation rose modestly (1-1.5%), while unemployment declined to 5%. Though inflation in the medium term had not reached the Fed’s mandate of 2% and the participation rate in employment had fallen, many in the banking industry called for the Fed to tighten in the name of “normalization.” The Federal Reserve in late December 2015 heeded the call for normalization and raised the Fed Funds rate by 25 basis points.

Since the Federal Reserve had never tightened when the Fed Funds rate was at 0%, and there was no empirical evidence to suggest otherwise, the Federal Reserve expected the impact of their monetary policy to be linear, much like the times when the Fed Funds rate was higher. The equation above demonstrates the Federal Reserve was right to expect the effects of monetary policy to be linear, but only if the Fed Funds rate was above 3%. By contrast, when the Fed Funds rate is near-zero, the impact of monetary policy is nonlinear and the effect of a 25 basis point tightening is quite substantial.

Global Deflation
In the 21st Century, the central banks are battling deflation coming from increased productivity and global competition for good jobs. The graph above shows US productivity growth and median family income over the past 65 years. The chart suggests that US productivity will continue while US wages remain weak. The chart also shows wages decoupling from productivity in the early 80s, when the US economy opened up globally, starting with Japan and the auto industry. In effect since the early 80s, the US worker has been forced to compete against lower global wages. In 1985 to help the US worker compete globally, the Plaza Accord was implemented to depreciate the U.S. dollar in relation to the Japanese Yen and German Deutsche Mark. Over the next four years, the US dollar lost 50% of its value, but even in the face of a devaluing currency, US inflation remained under control. When you look at the Fed Funds chart in the early 80s, you see the Fed Funds rate peaked just as the US economy opened up globally.

The empirical evidence demonstrates globalization is deflationary, even in the face of a weakening currency. The advanced economies in Asia, Europe and the Americas are faced with deflationary pressures and have governments with historically high debt. In short, the only stimulative capital available to these economies is from their central banks. Near-zero monetary policy provides the tools and the impact needed to stimulate these diverse economies while maintaining control over inflation.

Benefits of Near-Zero Monetary Policy
Near-Zero monetary policy is most effective against deflation at 0% because the availability of capital is near-infinite, as shown by the first graph. By maintaining a near-zero monetary policy, the central bank provides the necessary stimulus for economic growth while creating the ideal scenario for the central bank, the treasury, investment capital and consumer credit. Because the impact of monetary policy is nonlinear at near-zero, this enables the central bank to micro adjust the Fed Funds rate at near-zero and have an impact on inflation. For a sovereign nation, the ideal situation is having a treasury operate without a deficit and funding infrastructure projects at near-zero interest rates. To support an economy strong enough to generate tax revenue for the treasury to operate without a deficit, investment capital at near-zero interest rates would be available to the private sector to generate growth. And to support all this growth, consumer credit is available at near-zero interest rates to provide the consumer with the maximum purchasing power. The intended consequence is a healthy consumer and strong economic growth, enabling the sovereign nation to pay off its debt and fund infrastructure projects, while the central bank’s near-zero monetary policy achieves its goal of balancing full employment with 2% inflation.

Conclusion
Diverse economies in the 21st century are faced with deflationary pressures due to increasing productivity and globalization. Now that we have empirical evidence of the nonlinear impact of monetary policy and the equation to quantify it, near-zero monetary policy becomes a powerful tool for the central banks to stimulate their economy while controlling inflation. Near-zero monetary policy creates the ideal capitalistic environment, where the global economy operates with near infinite amount capital used to generate economic growth and prosperity.