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Asymmetric effects of monetary policy

Abdullah A Dewan   | Published: August 20, 2019 20:20:30


Multi-front intricate issues crop up, day in and day out, in the economic life of a nation that needs to be analysed and interpreted. A country's fiscal authority may not be equipped with analysts and experts to examine and understand these issues and take remedial measures to deter or soften their adverse effects on the economy. Neither most central banks in developing countries - Bangladesh Bank or BB is no exception - have the expertise to even diagnose and uncover the intricacies involved - let alone tackling them in a timely fashion in proper perspectives.  Even the world's most information-driven monetary policy body, the US Federal Reserve often grapples with the dilemma of fine-tuning the parameters of policy once the economy tends to deviate from its targeted growth path.

All economies - big or small, free market or authoritarian - are exposed to many unanticipated shocks. They include (1) unanticipated changes in consumer, business, and government spending, portfolio disturbances (e.g, unanticipated portfolio substitution of assets), money supply disturbances (banking activities) and supply shocks (energy prices, natural calamity, export - imports debacles, prolonged labour strikes etc.). Fiscal policy tools are very limited to respond to these shocks primarily because of legislative constrains and lack of experience and expertise. Only an independent central bank like the Federal Reserve (Fed) can resort to some policy activism to ameliorate the situation - even if complete success is not assured. 

The US Congress established three key objectives for monetary policy in the Federal Reserve Act: maximising employment, stabilising prices, and moderating long-term interest rates.  The Fed thus has the discretionary power to estimate what that full employment and inflation rate target would be. The current state of the US economy is healthy and by all measures, operating at full employment with unemployment rate at 3.7 per cent (lowest in 60 years). The annual inflation rate is 1.8 per cent (which is below the target rate of 2.0 per cent) for the 12 months ended July 2019 compared to 1.6 per cent previously, as published on August 13. The gross domestic product (GDP) growth is somewhat anemic with 2.65 per cent and 2.29 per cent in the last two quarters respectively. This low growth accompanied by the recent inversion of the long-term Treasury bond yield curve (topic of my follow-up article) is beckoning that a recession may be in the offing. President Donald Trump has been pressuring Fed Chairman Jerome Powel for some time now to slash the federal funds rate aggressively from the current 2:00-2:25 per cent to 1:00-1:25 per cent. He even tweeted this week asking the Fed to resort to Quantitative Easing (aggressively buying commercial banks' assets to increase their reserves and hence the money supply) - the ones that were used after the Great Recession. The Fed Chair is immune to such pressure as his job is protected by the US constitution. Besides, no one other than Trump's cronies agree with his policy prescriptions.

The Fed uses expansionary monetary policy (lower interest rate) to invigorate the economy when unemployment is high and resort to contractionary policy (increase interest rate) to preempt inflationary pressures when the economy appears overheating, indicating that labour market is tightening with wage pressures. Currently, the US economy is neither suffering from unemployment nor experiencing any inflationary pressure. That is why the Fed is resisting any pressure and proceeding with a cautious and measured approach.

Many research results and knowledge of the bygone days are now being replaced with new ideas as the economy confronts adverse shocks emanating from domestic as well as foreign sources. For example, the Federal Reserve's recurrent use of quantitative easing (targeting money stock instead of interest rate, given the bench mark interest rate was already near zero) was an innovative approach (never tried before 2008), which may have saved the US and the global economy from dipping into a depression of the likes of the 1930s Great Depression.

Recent studies suggest that the effects of monetary activism on unemployment (or output) are no longer easier done - the effects are likely to be asymmetric. Additionally, the strength or effectiveness of monetary policy actions (MPA) is also found to differ with the state of the economy. The evidence of asymmetry or unevenness in effects of an MPA is observed from a comparison of the relative effectiveness of both contractionary and expansionary policies in that contractionary actions increase unemployment (decreases output) more strongly than expansionary actions decrease it. For example, during the Great Recession (October 2007 to December 2010) the Fed lowered the federal funds rate (RFF) to near zero having little and slow impression on unemployment. Empirical evidence prior to the Great Recession have had somewhat mixed inference while recent studies confirm the asymmetric effects.  One might wonder: Why would the MPA be discriminatory or asymmetric?

There are several mitigating factors: (1) Lenders and borrowers behave differently under different economic and monetary conditions. For example, in the US when the Fed pursues contractionary policy by raising the RFF, market interest rates (lending rate and all other rates) tend to rise since all interest rates move in the same direction (co-movements). This is so because higher RFF entails higher cost of borrowing reserve money by commercial banks in the federal funds market (overnight reserves market). Naturally, banks would simply pass these higher rates on to their borrowers. However, raising lending rates too high would increase the likelihood of low creditworthy/risky borrowers (individuals and businesses) defaulting on their loans. The upshot of this dilemma is that bank, in order to limit risk exposure, may resort to credit rationing during a period of high interest rates. This discretionary activism by banks is likely to expunge a bigger slice of output leading to higher unemployment - thus augmenting the impact of contractionary policy. On the other hand, expansionary action may not necessarily accelerate surge in borrowing and spending if the prevailing demand has been weakened by economic downturns.  Unlike contractionary policy action, there is no binding restraint on consumers to borrow and spend

A second reason why expansionary policy might be relatively less effective than contractionary policy arises from wage and price stickiness downward (wage stickiness is partly due to labour union contracts and emotional inertia of losing income). Prices usually are slow to adjust downward- implying stickiness.  Additionally, businesses are cautions to slice wages down for fear of hurting worker morale and loyalty. The dual quandary of downward price and wage rigidity tend to persuade firms to respond to contractionary monetary policy by cutting output rather than cutting prices. On the other hand, prices and wages are not as sticky upwardly, nevertheless. For example, firms always react to inflation by raising prices and wages gradually - albeit in varying degrees. This explains as to why easy money policy (low interest policy) is more likely to prompt a change in prices rather than output.

As noted above, effectiveness of monetary policy depends on the state of the economy and understanding of the intricacies involved. As one must not start taking antibiotic for sneezing and coughing and so is the use of interest rate may not be resorted to as an economy shows some minor occasional hiccups. 

Abdullah A Dewan, formerly a physicist and anuclear engineer at BAEC, is professor of Economics at Eastern Michigan University, USA.

adewan@emich.edu

 

 

 

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