The FINANCIAL — Changes to key interest rates by central banks have a significant impact on economic activity during periods when the economy is expanding.
Unfortunately, they seem to have virtually no effect during recessions – the time when the stimulus of monetary policy is most needed, according to the research by Professor Silvana Tenreyro and Gregory Thwaites, published by the new Centre for Macroeconomics at the London School of Economics.
The study focuses on the Fed Funds rate, the main monetary policy instrument used by the US Federal Reserve and the counterpart of the Bank Rate set monthly by the Bank of England. The researchers explore the effect of changes in this ‘policy rate’ on US macroeconomic activity over a 40-year period – from 1969 until 2008. Whether central bank interventions of this kind can stimulate activity is a key issue for policy.
The analysis shows that nearly all of the effect of the policy rate on economic activity over the business cycle is attributable to changes made during good times – and it is particularly driven by the responsiveness to rate changes of business investment and consumer spending on durable goods.
A possible explanation is that during recessions, many people decide simply not to buy expensive durables and hence a change in the interest rate does not affect how much they buy. In good times, in contrast, people are buying durables and the level of the interest rate may affect how much they buy, according to the report.
Whatever the precise mechanism, the researchers find that in an expansion, output and inflation fall in response to an increase in the policy rate in the textbook fashion. But in a recession, the responses of output and inflation to a rate cut are negligible.
"Our findings have important implications for the design of economic policy," Professor Tenreyro said. "If changes in the policy rate have little impact in a recession, central banks need to resort to other measures to achieve the desired expansionary effect – ‘quantitative easing’ and ‘forward guidance’ are current examples," he added.
"Our results also suggest that policy-makers may need to rely more heavily on fiscal or financial policies to stabilise the economy in a deep or protracted slump," he added.
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