The neutral rate and the limits of monetary policy

Is monetary policy tight or loose?

Memorize

Compare the policy rate with the neutral rate of interest : the rate that neither stimulates nor holds back the economy. When the policy rate is above neutral, policy is contractionary ; it is designed to slow the growth of money and the economy. When it is below neutral, policy is expansionary ; it adds liquidity and supports growth.

Policy rate vs neutral rateneutral = real trend growth + long-run expected inflation

• Policy rate above neutral Memorize contractionary: slows money growth and the economy
• Policy rate equal to neutral Memorize neither stimulates nor holds back the economy; stable inflation
• Policy rate below neutral Memorize expansionary: adds liquidity, supports growth

Economists agree that the neutral rate has two components: the real trend rate of growth of the economy (the rate that can be sustained with stable inflation) and long-run expected inflation, which is the inflation target when the central bank is credible.

$$N = g + \pi^{e}$$

The gap between the policy rate and neutral gives the direction of the stance.

$$G = P - N$$

A positive $G$ is contractionary, a negative one expansionary, and zero is neutral.

The neutral rate is an estimate, and different economists reach different numbers, so they can also disagree about the stance. Estimates of trend growth often fall after a credit bust, when governments and households must pay down debt and cut spending. In practice, many central banks also publish their own view of neutral.

Exam tip Never compare the policy rate with the inflation target alone. Add trend growth first, then compare.

What caused the inflation?

Use it

Before tightening or easing, the central bank asks where the shock came from.

Inflation rises above target

• Demand shock Use it confidence and spending surge
  • Prices and output rise together
  • Tightening fits
• Supply shock Use it for example, a jump in energy prices
  • Prices rise while output falls
  • Tightening deepens the downturn the bank may look through it

• A demand shock is a surge in confidence, consumption and investment. Inflation and output rise together, so tightening is the right response.
• A supply shock is, for example, a jump in energy prices. Inflation rises while output slows. Raising interest rates here can make a bad situation worse: consumers already face higher fuel costs and may lose jobs, so higher rates deepen the downturn, and inflation may fall sharply afterwards anyway. The bank might choose to look through the price rise.

Where does monetary policy fall short?

Memorize

The limits fall into two groups: problems in the transmission mechanism, and the weakness of rate cuts in deflation.

Why policy can fall short

• Cannot control the money supply fully Memorize deposits and bank lending are decided by others
• Transmission can break
  • Long rates follow expectations, not the policy rate a hike seen as causing recession can lower long yields
  • Bond market vigilantes Know the idea push long yields up on inflation fears, down on slump fears
• Liquidity trap Memorize extra money no longer lowers rates or lifts activity
• Deflation Memorize rates cannot fall much below zero; real debt rises; spending is delayed
• Response: quantitative easing Memorize large-scale asset purchases, plus promises of low rates

The money supply is not fully in the central bank’s hands. It cannot control how much households and companies deposit in banks, nor how willing banks are to lend. So it cannot always control the money supply.

Long rates follow expectations. Long-term rates reflect the expected path of short rates. If bond investors think a hike is excessive and will cause a recession, long yields can fall, which makes long-term borrowing cheaper and loosens conditions despite the hike. Bond market vigilantes are bond investors who sell long-dated bonds (pushing yields up) when they think the central bank is losing control of inflation, and buy them (pushing yields down) when they fear a sharp slowdown. A credible central bank needs them less.

Liquidity trap. In the extreme, the demand for money becomes infinitely elastic: people are willing to hold any extra money without any change in the interest rate. Extra money then neither lowers rates nor lifts activity, and policy can become completely ineffective. A liquidity trap is typically associated with deflation.

Deflation. Deflation is a broad, sustained fall in the general price level. It is harder for conventional policy to handle than inflation, because nominal rates cannot be cut much below zero. Falling prices also raise the real value of debt and encourage consumers to postpone purchases, which weakens demand and feeds the deflation.

The response: quantitative easing

Quantitative easing (QE) is operationally like open market purchases, but on a much larger scale. The central bank buys government bonds, mortgage bonds or other assets from the private sector and pays with newly created reserves. The aim is to push down long-term rates and encourage lending. It is often paired with a promise to keep policy rates low for a long time (forward guidance).

QE has limits. Banks that see a weak economy may hold the extra reserves rather than lend them, and a central bank that buys risky assets can incur losses and weaken confidence in its own money.

Go deeper Why neutral-rate estimates fell after credit busts

Know the idea

When households and governments borrowed heavily and then had to repay, trend growth looked weaker than before, so analysts cut their estimates of the neutral rate. A policy rate that had looked neutral could then be seen as tight. This is the practical meaning of “neutral is an estimate”.

Go deeper A deflation trap in a large economy

Know the idea

After an asset price collapse, one large economy saw weak spending, falling prices and rising real debt together. Its central bank cut rates to zero, then combined QE with a promise not to raise short rates until deflation had ended. Results were mixed: inflation turned positive for a while and then fell back, which many take as evidence of the limits of monetary policy.