Intro: As we explained in ‘Why Interest Rate Cuts Rarely Stimulate Economic Growth’, the majority of interest rate cuts are ineffective at stimulating economic growth as they tend to merely reflect changes in the saving/investment balance that have already occurred. However, central banks can, and do, engage in ‘activist’ monetary policy aimed at boosting asset prices in a bid to stimulate growth in the short term. Under certain circumstances these efforts can support near-term growth, but they tend to do so at the detriment of future growth and raise risks in the financial system.
Activist monetary policy is a loose term but generally applies when central banks reduce real interest rates significantly below the rate that would naturally exist to balance out savings and investment. While it is impossible to say where the natural rate of interest is, if real interest rates are negative then this is a sign that they are out of line with the fundamentals.
Conventional wisdom argues that activist monetary policy can boost ‘aggregate demand’ by raising asset prices leading to a rise in consumption and production; something known as the wealth effect. However, while growth in production of a certain good is driven by demand for that good relative to others, the demand for all goods and services in an economy is infinite. Growth depends on how much of this demand can be satisfied by the available supply, which depends on profit opportunities.
When real rates fall and asset prices rise this makes borrowing cheaper and may improve economic confidence. This may increase the perceived willingness of businesses to borrow and invest and consumers to borrow and consume. However, generally speaking if the fall in real interest rates is not driven by an increase in savings, any increase in investment or consumer demand from those who benefit from cheaper borrowing or rising asset prices will tend to come at the expense of investment or consumption by those who do not benefit.
Monetary Stimulus ‘Works’ by Preventing Necessary Economic Rebalancing
Monetary policy only tends to ‘work’ in terms of stimulating short-term growth if it prevents a rebalancing of the economy following a build-up of economic distortions. Recessions or slowdowns occur when the vast structure of capital and intermediate goods being produced does not fully align with what consumers ultimately demand and the real resources available to produce these goods. This is either because consumer preferences change or costs rise, undermine profits. Falling asset prices (as well as rising corporate borrowing costs) are often the trigger that causes consumer confidence or corporate profitability to decline. Businesses must then reorganise and start to produce the kinds of goods that consumers want, and this readjustment process, while essential, often results in lower overall economic output, known as a recession.
Monetary stimulus can help to prevent a fall in overall real GDP by preventing this adjustment from taking place. For example, if in response to a sharp drop in asset prices, consumer savings rates surge causing a painful readjustment for businesses, an interest rate cut can support house prices, preventing a rise in the savings rate and preventing the decline in profitability in consumer-focused industries. Similarly, if corporate bond yields are rising, putting pressure on corporate profits, an interest rate cut can temporarily reverse this. Nonetheless, the extent to which monetary stimulus ‘works’ in the short term is proportional to the severity of the inevitable economic weakness.
Risks Posed by Artificially Low Rates
It is not necessarily the case that monetary stimulus acts as a net positive for growth even if it is successful in preventing certain economic imbalances from unwinding as other distortions can emerge or be triggered by the stimulus. This is particularly the case if the country’s economic fundamentals are weak, savings rates are low, and real interest rates are already low.
For example, imagine if the UK falls into recession post Brexit due to a surge in the personal savings rate, a monetary stimulus policy aimed at supporting asset prices and consumer spending would be likely to further undermine profitability in other sectors of the economy. This is because the savings rate is already so low that the resources available for investment are becoming scarce and increasing the economy’s reliance on external borrowing. The pound would likely decline and this would create a shock to businesses reliant on imports which would offset any positive impact of the monetary stimulus.
Over the longer term, excessively loose monetary policy will undermine wealth creation and encourage financial speculation, undermining financial stability. This is because when interest rates are set below the natural rate, this gives investors false signals about the availability of resources and thus the future profitability of their investments. During this time, the investment goods that are produced do not align with the end demand from consumers and losses result. The damage tends to be amplified if low rates trigger financial market bubbles. As investors chase returns in risky assets, resources are increasingly diverted towards more speculative and less productive investments.