Confronting the limits of monetary policy
The ability of interest rates to guide prices and the economy is diminishing
Tej Parikh
From left, Bank of England governor Andrew Bailey, European Central Bank president Christine Lagarde, Bank of Japan governor Kazuo Ueda and Federal Reserve chair Jay Powell. Interest rates are a blunt tool for guiding the economy © REUTERSWelcome back. Central bankers are often at pains to remind us that setting interest rates is a “blunt tool” for guiding the economy and, hence, prices.
But has it become blunter?
This week, I outline a few reasons why it might have in advanced economies — and why that matters.
A policy rate change transmits into the real economy through multiple channels.
At a basic level, it influences prices in financial markets, which impacts the cost of credit and exchange rates.
This, in turn, affects households’ and businesses’ behaviour.
The mechanism is rarely smooth, and suffers from “long and variable lags”.
But more recently, a high prevalence of debt locked in at fixed rates has damped the effect of rate changes even more.
Over the past two decades, floating-rate mortgages — which are linked to central bank rates — have become less popular in the US, UK and major euro area economies.
Longer-term, fixed-rate products are now more dominant.
“The shift in the types of mortgages means monetary policy definitely takes longer to work its way into households’ payments,” says Paul Dales, chief UK economist at Capital Economics.
In a blog in May, European Central Bank economists noted that despite recent rate cuts, average mortgage rates would rise further and drag on consumption “at least until 2030.”
That’s because of households remortgaging on to higher rates after completing long-term fixed deals.
Businesses have embraced fixed rates too.
Floating-rate US corporate bond issuance has dropped from about 30 per cent before the global financial crisis to just over 15 per cent now.
The changing sectoral composition of advanced economies has also reduced their sensitivity to rate changes.
“The relative weight of rate-sensitive capital-intensive sectors, such as manufacturing and construction, has diminished in favour of services, which are more labour-intensive and less responsive to interest rates,” says Marco Casiraghi, director at Evercore ISI.
“Households also spend less on durable goods and more on services, for which they do not typically need to borrow.”
Indeed, calculations by Oxford Economics show the output of goods-producing sectors in advanced economies has been squeezed by rate rises since the start of 2022, while services have remained resilient.
Jobs have followed the same pattern.
That said, services such as IT and research and development, which might be classified as rate-sensitive in theory (because of their capital intensity), have grown as a share of activity in advanced economies.
However, they been less responsive to rate rises, particularly in this cycle, explains Nico Palesch, industry economist at OE.
“First, investments in software, cloud services and R&D tend to be seen as structural and high return, making them less dependent on the rate cycle.
This is evident in the current artificial intelligence build-out,” he says.
“Also the dominant day-to-day output in these sectors — such as telecoms services and enterprise software adoption — is pretty insensitive to rates,” he adds.
Relatedly, as I outlined in the August 10 edition of this newsletter, spending on intangible assets — including intellectual property, software and code — has surpassed tangible investments as a share of GDP in major economies since the global financial crisis.
Research by the Federal Reserve Bank of Chicago finds investment in non-physical assets is less sensitive to interest rates than expenditure on factories and equipment.
That’s because intangibles tend to be financed using internal funds or equity, being harder to pledge as collateral for loans.
Paul Donovan, chief economist at UBS Global Wealth Management, adds that physical capital stock tends to be utilised more efficiently today, too.
“Thirty years ago, if you wanted to go into retail you needed a physical shopfront,” he says.
“Now you need an Etsy account, a smartphone with a reasonable quality camera, and your bedroom becomes your warehouse.”
Financing also matters.
In this cycle, the AI investment boom in physical infrastructure, including data centres, has not been underpinned by debt.
“Hyperscalers are financing capital expenditure out of cash flows, not through borrowing,” says Michael Crook, chief investment officer at Mill Creek Capital Advisors.
“Approximately 70 per cent of current operating cash flows are being routed for AI investment.”
In effect, while high interest rates have squeezed manufacturing and residential construction, tech-related spending has strengthened. And AI-linked stock prices have continued to push higher.
In the US in particular, a rising equity market — owing to the high market capitalisation share of tech firms — has generated looser financial conditions, and offset the effect of higher policy rates.
These are just snapshots of the structural changes and idiosyncrasies that have further blunted monetary policy this cycle.
What’s the upshot of reduced rate sensitivity?
First, it makes the effects of changes in monetary policy weaker and take longer to manifest in the economy, so central bankers need to push borrowing costs higher or lower than in the past to make an equivalent impact, notes Evercore’s Casiraghi.
Second, it means the transmission of monetary policy depends on narrower rate-sensitive segments of the economy, especially households and businesses with short-term and variable loans.
This raises the risk of putting excess — or too little — interest rate pressure on certain sectors.
Today’s global economic backdrop creates further challenges.
Using interest rates to guide the economy and prices is easier when shocks are infrequent.
Rising policy uncertainty and supply shocks — emanating from shifts in trade patterns, geopolitics and energy resources — makes monetary policy, which primarily impacts the demand side, much harder to calibrate.
None of this means monetary policy is ineffective or inconsequential.
Credible independent central banks anchor inflation expectations.
In the current cycle, tightening across advanced economies has slowed certain sectors, raised the cost of credit, and brought inflation closer to the 2 per cent target.
Sectoral rate-sensitivity can also change between cycles.
For instance, Goldman Sachs last week noted that AI spending is increasingly being fuelled by debt.
But long-term structural changes are eroding rate-setters’ already limited powers.
Why does this matter?
Monetary policy has become the focal tool to guide economies in the west.
Fiscal policy faces political and budget constraints, and supply-side reforms take longer than the electoral cycle to bear fruit.
The investor and media hubbub around each central bank decision and economic data release inadvertently imbues rate-setting with a strength it doesn’t possess.
But fiscal and supply-side policies are more incisive instruments for guiding the economy and prices.
Tax and spending decisions can be targeted.
Budgetary discipline shapes long-term borrowing costs.
Land, labour, energy and capital reforms can boost long-run supply and resilience.
As the effects of monetary policy become more lagged and variable, other tools will need to pick up the burden of economic management.
Central bankers can’t talk about the bluntness of interest rate-setting enough.
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