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Ever come up against an unreliable shower tap? Turn slightly and it becomes too hot. Twist back and it takes ages to cool down. Well, that is the analogy Milton Friedman is said to have used to explain the difficulties of using the tools of monetary policy, which have “long and variable” lags, to target inflation.
But we seem to have forgotten Friedman’s warnings — that monetary policy is a blunt tool. First, the era of low inflation from the mid-1980s until the global financial crisis enhanced the credibility of central banks but perhaps also exaggerated their power. Second, after the crash, economies became more dependent on rate-setters given the only limited fiscal stimulus. Programmes and tools such as quantitative easing, yield curve control and forward guidance were introduced. This raised central banks’ influence on markets.
Today, central bank whispering is a full-time occupation. The regularity of committee meetings has fused with high-frequency trading, the 24-hour news cycle and social media. “Interest rates change daily, partly in anticipation of what central banks will do next. This transfers wealth across financial markets,” said Ricardo Reis, a professor at the London School of Economics. “It creates an obsession with monetary policy — even though the small daily moves in rates have a negligible impact on inflation.”
Inflation would indeed be higher today had central banks not raised rates. But this latest inflationary episode was driven by supply shocks, which interest rates cannot directly and rapidly remedy. Central bankers made mistakes early in this cycle, but the expectations on them were too high to begin with.
Monetary policy impacts demand in an imprecise manner. A change in bank rate or balance sheet operation influences financial market prices. That then has a knock-on impact on the cost of credit to the real economy. But the mechanism is rarely smooth and varies depending on the macro context. This rate cycle has highlighted that.
First, the rise of fixed-rate loans — and pandemic savings — have stunted the impact of rate rises. In the UK, the share of floating-rate mortgages fell from 70 per cent to 15 per cent in the decade to 2022, according to Capital Economics. In America, 30-year fixed mortgages have long been common, but the share of adjustable rate new mortgages has dropped sharply since the 1980s. Floating-rate US corporate bond issuance has also dropped from about 30 per cent prior to the financial crisis in 2007-08, to about 15 per cent now, Capital Economics adds.
Second, the Phillips curve relationship — that lower inflation and high unemployment accompany each other — has also not been reliable in this cycle. The post-pandemic jobs market has been unusual due to a combination of falling participation rates, shifting work preferences, and labour hoarding. This could explain job market resilience in the face of higher rates.
Third, market expectations have added complexity. Goldman Sachs’ US Financial Conditions index — a gauge of financial market tightness — has loosened back to summer 2023 levels. The notion that the US Federal Reserve had reached its peak rate led to a rally in equity and bond markets. This impacts real economic activity too, with priced-in rate cuts supporting a recovery in housing markets.
These factors have reduced the potency of monetary policy in this cycle, and could persist. The upshot is that rates need to go higher to deliver a given economic impact, and its lags — often estimated between 18-24 months — take longer. Sanjay Raja, chief UK economist at Deutsche Bank, says this creates more volatility and the risk of errors. “We estimate that only 70 per cent of [UK] rate hikes have filtered through to the economy,” he said. Raja thinks the Bank of England’s Monetary Policy Committee “runs the risk of overtightening”.
Another lesson is that the effectiveness of monetary policy also depends on the structural economic drivers around it. After all, the era of benign inflation before the financial crisis was bolstered by elastic production and energy supplies. Looking ahead, using rates with unreliable lags to influence demand is a recipe for volatility, as supply shocks from regionalisation, geopolitics and less supportive demographics continue — unless there are offsetting productivity gains.
As Friedman noted, depending on monetary policy is bound to aggravate rather than ameliorate the economic cycle. Fiscal and supply-side policy must get greater emphasis in the price stability debate. After all, a faulty faucet is even more useless if the plumbing has gone awry.