the monetary policy transmission process: what do we know ... · the monetary policy transmission...

September 1995Reserve Bank of Australia Bulletin

19

The Monetary Policy TransmissionProcess: What Do We Know?(And What Don’t We Know?)

Talk by Assistant Governor, Dr S.A. Grenville,to Australian Business Economists, Sydney,28 August 1995.

Monetary policy is often seen as a principalinstrument in the counter-cyclical armoury,mainly directed at smoothing the businesscycle. This is an important focus of policy –important both for its own sake and becausecyclical variations in demand are the primaryliving force of inflation. In recent years,however, the longer-term aspects of monetarypolicy have come to the fore. Monetary policyconcerned with more than smoothing theswings in economic activity. While a larger,output gap and a stronger exchange rate bothay an important role in containing inflationarypressures over the course of the cycle,achieving the nirvana of full employment plusprice stability requires low, stable pr iceexpectations.

This raises a number of issues which arethe object of vigorous debate at present amongmonetary authorities world-wide: issues suchthe appropriate objectives for a central bankand the desirable degree of independence.These are not on my agenda today. Nor will Iinto the detail of our operating procedures (seeRankin (1992)). I’ll confine myself to scribingthe links between the RBA’s instrument (thecash rate) and the ultimate objectives –economic activity and inflation. The RBA usesthe operating technique which has comeuniversal in countries with deregulatedfinancial markets: the Bank can influence

liquidity in the payments clearing system, andis allows us to shift interest rates at the veryshort end of the yield curve. This cash rate isused as the operating instrument to influenceactivity and prices.

The transmission process can be seen asoperating something like this:

Real output depends, inter alia, on realinterest rates. Higher interest rates reduceactivity and create an ‘output gap’ – adeviation of actual’GDP from potential.Inflation responds to this output gap, bothdirectly and through the indirect effect onwages. Changes in interest rates also affect theexchange rate, which feeds directly into priceswhile at the same time influencing activity.Price expectations depend on past priceincreases, and also on the anti-inflationreputation which the central bank builds upover time.

Schematically, it might look like this:

The Monetary Policy Transmission Process: What Do We Know? (And What Don’t We Know?) September 1995

20

The Channels

Those who like formality and precision havesuggested the following classification for thetransmission channels of monetary policy:• inter-temporal substitution;• the exchange rate,• cash flow,• wealth/assets effects; and• credit rationing effects, relating to the

supply side of intermediation.I’ll touch lightly on the first two and the

last two, because I have little to add to theexisting descriptions, and because the cashflow channel has become more prominent inour own thinking.

Inter-Temporal Substitution

With the interest rate as the operatinginstrument of monetary policy, it is naturalenough to see it as the main transmissionchannel. Decisions have to be made betweenspending now or later, and the interest raterepresents the cost of this inter-temporalchoice. The interest rate is the reward forpostponing the spending decision – the higherthe interest rate, the more spending decisionswill be postponed. For businesses, the interestrate is the fulcrum of the cost-of-capitalcalculations used to decide whether, andwhen, to invest.

While this is straight-forward at an intuitivelevel, it may be more difficult to observe inpractice. Most people would accept that therelevant interest rate here should be a realinterest rate – some nominal interest rateadjusted for the ex-ante expected inflation rateof the person making the decision. Expectedinflation is, of course, unobservable. Also,which nominal interest rate should be used ?Policy is implemented through the cash rate,but no one thinks this goes directly intocost-of-capital or similar calculations. Theusual story is that the cash rate influences thebill rate and overdraft rate, and these are the

relevant rates because most borrowing takesplace at these rates. The first part of this storyis certainly true – cash rates closely determinebill rates and overdraft rates.1 The second legis less obvious: what rate of interest goes intothe’inter-temporal decision? For a projectwhich will have a life of two years, the expectedinterest rate over that two-year period is therelevant one. The project may be funded at adifferent maturity – two-year fixed-ratefunding may not be available, or the investormay be more comfortable with a variable rate.But it is interest rates over a two-year timehorizon which should determine whether theproject goes ahead or not.

In practice, the entire term structureof interest rates probably matters forinter-temporal substitution. Differentinvestment projects have different timehorizons, and so different interest rates arerelevant. What people expect interest rates todo can be very important. In 1988, mostpeople at the time judged the rises in interestrates to be short-lived, with few anticipatingthat interest rates would go as high as theydid, or stay high for as long as they did. Thismay help to explain why monetary policyseemed slow to take hold at that time.

The Exchange Rate

A second channel is the exchange rate. Thefloating of the exchange rate in December1983 fundamentally changed the waymonetary policy worked. Higher interest ratesappreciate the exchange rate, which spillsdemand into imports (retarding growth in thetradeables sector) and directly influences theprices of tradeables. The more open theeconomy, the more important this channel(Gruen and Shuetrim 1994).

While no-one doubts that this is animportant mechanism for the operation ofmonetary policy, it is very hard to isolate thischannel in practice. Even the first stage of theprocess – from the cash rate to the exchangerate – is hard to identify. Over the past decade,there have been times (such as in 1988) whenhigher interest rates have pushed up the

1. For details on this (including the changing relationship between cash rates and lending rates), see Lowe (1995).


21

exchange rate (i.e. a positive relationshipbetween the two), but there have also beenepisodes (such as in 1985 and 1986) when aweakening exchange rate caused the Bank toraise interest rates (a negative relationship).Thus the past 10 years contained a mixtureof the positive and negative, with no reliablemeans of separating them (Macfarlane andTease 1989).

An investment decision should passtwo hurdles – it must be viable in theinter-temporal sense discussed above, basedon real interest rates. Secondly, the borrowermust have enough cash flow to meet the debtservicing: this depends on nominal interestrates. High inflation usually goes with highnominal interest rates, so high inflation maywell impose cash flow constraints onborrowing, even if the underlying project isviable. Of course, if borrowers haveunrestricted access to funds, they could justborrow their way out of the cash flowconstraint: but most borrowers are not ableto do this.2

The classic illustration of this phenomenonis mortgage borrowing. The conventionalhousing ‘affordability indices’ (such as theCommonwealth Bank/HIA and the REIA)measure cash flow, not real interest rates. 1991to 1995 saw the strongest growth in borrowingfor dwellings in two decades, but real interestrates were not especially low. The expansionwas fuelled by the highest level of‘affordability’ in the deregulation period, inturn a reflection of the lower nominal interestrates in the early 1990s. There had beenprevious periods when affordability was asgood, but the ability to borrow from the

2. This can be seen as the ‘front-end loading’ effect, where high inflation (and thus high nominal interest rates)results in high debt servicing relative to income in the early years of the loan. General inflation raises borrowers’incomes over the life of the loan, so the repayment burden falls: but the heavier real repayment burden in the earlyyears excludes some potential borrowers.

Graph 1

Graph 2

Cash Flow

The notion of a cash-flow constraint has alot of intuitive appeal: individuals’ decisionsare often made on the basis of available cash,rather than some sharp-pencil calculation ofrates of return and costs of capital. The twodefining characteristics of cash flow are thatit depends on nominal rates; and, for it to affectbehaviour, there must be some liquidityconstraint – i.e. people are not able to borrowas much as they want to at the goinginterest rate.

There are a couple of different aspects ofcash flow. The first is the influence of cashflow on decisions by the potential newborrowers; secondly, the impact on interestrate changes on the cash flow of existingborrowers.


22

regulated banking system was constrained.This time, banks were ready and eager to lend.

While this form of cash-flow constraint ismost clearly seen for households, it alsoapplies to businesses. It was probably quiteimportant in the late 1980s and early 1990s(see Mills, Morling and Tease (1994)). It ispar ticularly important for small- andmedium-sized firms with limited access toequity.

The previous paragraphs described theinfluence of cash flow on the borrowingdecision by a potential new borrower. Higherinterest rates also affect the cash flow of peoplewho have borrowed at an earlier time and stillhave an outstanding variable rate loan. Thesepeople may be forced to trim theirexpenditure, as they adapt to the higherinterest rates.

At an anecdotal level, this might seem to bea very powerful transmission channel – a risein interest rates sets off many complaints fromborrowers who have been adversely affected.There is, however, a complication: householdsare both borrowers and lenders. Higherinterest rates increase income of thosehouseholds who are lenders: will they makechanges to their expenditure which roughlyoffset the changed expenditure of borrowers?3

In practice, households in aggregate makenet interest payments, although the amount ismuch smaller than the gross flows. Higherinterest rates will trim households’ net cashflow, but the effect is not large. For aone-percentage-point increase in interestrates, about three-quarters of this will bepassed on to lenders in the form of higherinterest income. Even if this was a perfectwash-out (with borrower and lender incomeschanging by the same amount), there wouldstill be the potential for a significant cash floweffect, through the different expenditurebehaviour of borrowers and lenders inresponse to interest rate increases. It is likely

(although it cannot be established empirically)that a good number of borrowers are liquidityconstrained, and hence will probably respondmore than lenders. Lenders’ expenditure maynot be much affected: they may regard thehigher interest income as temporary, or theymay see the need to save it in order to preservethe real value of their principal. It is certainlytrue that there are more people ready tocriticise and complain about an interest rateincrease than there are who welcome it, inpublic at least.

The importance of cash flow has probablychanged as Australia moved into the 1990s.The first cash flow channel (the ‘front-endloading’ of borrowing) has diminished inimportance, with lower nominal interest rates.As a result of this (and a financial systemwhich was readier to lend to households),households have geared up more, making thesecond aspect of cash flow (the impact of aninterest rate increase on existing borrowers)potentially larger. Off-setting this, to someextent, is the reduced gearing of businesses.

Wealth/Asset Effects

When people think of asset-price influences,they usually have in mind the experience ofthe late 1980s. There seems little doubt thatthese changes in asset prices had verysubstantial effects. While asset prices areimportant,4 they have, to some extent, a lifeof their own separate from the influence ofmonetary policy. They can only be seen as achannel of monetary policy to the extent thatthey have a relatively predictable relationshipwith interest rates. There is no doubt that thereis a link between cash rates and bond prices,and this in turn affects equity prices(Tease 1993). Higher interest rates should alsodampen property price increases. Equityprices feed into the cost of capital, and assetvalues affect collateral and hence the readinessof banks to lend. This relationship will,

3. Some have even suggested that, for households, the cash flow effect on borrowers is more than outweighed by thecash flow effect on lenders, because households are net holders of financial assets. While households are net assetholders, they are net payers of interest: see page 35 of the RBA’s 1995 Annual Report.

4. The UK experience has shown how falling housing prices can impose serious constraints on households, and thecurrent experience in Japan provides another example of the importance of asset prices.


23

however, often be submerged by morepowerful forces driving asset prices – amplydemonstrated by the experience of the late1980s, which reflected a combination offinancial deregulation, the interaction ofinflation and the tax system, and rampant‘animal spirits’.

Credit Supply Effects

Lenders don’t have perfect knowledge ofborrowers.5 Hence lenders build ‘risk‘premia’into their interest rates. When the Bank raisesthe cash rate, these risk premia may also rise,altering the supply of credit and influencingthe amount of investment which is financed.They may, instead of raising interest rates toreflect the higher risk, impose some form ofrationing – raising the loan-to-valuation ratio– or they may require more collateral. Theymay go further, and simply not lend to riskiercustomers. This is the phenomenon describedby Stiglitz and Weiss (1981). If interest ratesrise, some of the most credit-worthyborrowers will not go ahead with theirprojects: borrowers who have a greaterreadiness to default on their borrowing willcontinue to seek to borrow. In thesecircumstances, banks will respond to highercash rates by rationing credit, to ensure thattheir average default rates remain low.Whether the supply limitation takes placethrough credit refusals or higher risk premiabuilt into lending rates, the outcome is thesame. As interest rates rise, some projectswhich are still viable at the higher interestrates don’t go ahead. All this seems sensibleenough, but I would have to say that there isvery little evidence of this effect in operationin the asset boom of the late 1980s.

Expectations

The description so far has covered linkagesfrom policy to activity and prices which are

conceptually precise (even if they aresometimes hard to identify in practice).

In attempting to track the well-definedchannels of transmission, there is a danger ofmissing the wood for the trees. Behaviour isgreatly influenced, as well, by generalperceptions of the overall economicenvironment, and policy will impinge on this.When investment decisions are being made,it is not only the cost of capital and cash flowthat matter. Central to the investment decisionis a forecast of the general economic climatein which the project will operate (‘businesssentiment’ or ‘animal spirits’). This climate isinfluenced, not just via interest rates, but byperceptions about the stance of policy: do theauthorities want the economy to grow faster,or are they trying to rein in excessive demandto help price stability?6 This nebulous butpotent policy link adds to the difficulty ofcalibrating monetary policy. For themechanical links (such as the inter-temporalchannel), the impact of policy might beexpected to be smoothly incremental –1 per cent interest increase has a certain effect,2 per cent has twice the effect. Expectationalchannels might, however, be discontinuous –no effect following a couple of policy changes,then a further tweak of policy produces a largechange in perceptions.

General perceptions about the stance ofpolicy will be important, also, for inflation.The public’s price expectations will beconditioned by their view on how serious thecentral bank is about achieving andmaintaining price stability. Monetary policyactions (or, for that matter, inactions) will beinterpreted by the public in this context, andhave the potential to be a powerful and directinfluence on prices. A central bank’sreputation may well be enough to counteradverse influences: e.g. strong credibilitywould help maintain price stability even whenthere were potentially-inflationary demand orwage pressures. This thinking lies behind agood bit of the debate on what constitutes‘best practice’ among central banks. A decade

5. In the jargon, there are ‘information assymetries’ and ‘principal/agent’ problems (Stiglitz andWeiss 1981).

6. For households, ‘unfavourable’ news about interest rates was very important in shifting consumer sentiment in thelatter part of 1994, as shown by the Melbourne Institute Consumer Sentiment Survey.


24

or so ago there was a hope that, if the monetaryauthorities made a sufficiently firmcommitment to price stability (perhapsrestricting their room for policy manoeuvreby a simple unambiguous price stability rule),this action would in itself significantly reduceprice expectations. This is still an attractiveidea, but the experience of the last decadehas not lent much support to this view. InNew Zealand, a firm and crediblecommitment to price stability was made in1989. Graph 3 shows the usual sequence,familiar from the similar Australian experience– price expectations came down when (andonly when) actual inflation fell. This is not tosay that credibility is unimportant: only thatit can’t be bought cheaply. It is, at the sametime, a fragile quality which can be easily lost.This may be another example where therewards of virtue are small, but thepunishment for neglect of reputation is high.

be re-inforced by the impact on activity. Nosingle mechanism by itself is important, butcollectively they build on one another. A bitof inter-temporal substitution by householdsleads to lower sales for firms. In turn,corporate cash flow tightens, profits declineand share prices fall. Next comes lowerinvestment and weaker employment. Thistightens household cash flow further and thereare second-round effects.

Housing illustrates another aspect ofinteraction. When interest rates rose in thesecond half of 1994, the housing cycle was,already, in its mature phase. The upswing hadlasted four years, and houses were being builtat a rate in excess of the usual measures ofunderlying demand. In these circumstancesthe (apparent) impact of interest rate increaseswas quicker and more powerful than it wouldhave been if the interest rate increase hadoccurred earlier in the upswing.

Quantification

In attempting to quantify all this, we willfollow through the transmission process frominterest rates to activity, and then look at theforces operating on prices – via activity, theexchange rate, and price expectations.

Activity

While no-one doubts that higher interestrates will tend to discourage expenditure, itdoes not leap out from the data (Graph 4).The relationship seems to be perverse formuch of the cycle: high rates of interest oftencoincide with high expenditure. The answeris, of course, that there is a positive policyreaction relationship from expenditure tointerest rates – when activity is high or growingfast, policy will be tightening so interest ratesare rising. For much of the cycle, thisdominates the negative relationship frominterest rates to activity.

All this seems obvious enough, but it is afundamental difficulty when trying to quantify

Graph 3

Interactions

It is also true that the interaction of thechannels may make them much morepowerful (see, for Canada, Duguay (1994)).An interest rate increase both slows activityand raises the exchange rate. The impact ofthe higher exchange rate on import prices will


25

the interest rate transmission channel. While,in principle, it might be possible to specify asystem of equations which would identify theseparate forces at work, everything is movingto the same basic tune – dictated by the cycle.It should make us very cautious in relying onprecise estimates (of the sort quoted below).It seems most unlikely that we will be able todevelop a series of econometric equationswhich capture the full complexity of thechanging relationships between policyinstruments and objectives. Such equationsare one input to our thinking, not a substitutefor detailed examination of the specificcircumstances of each individual episode.

Within the Bank, we have developed somerelatively simple equations which explore thelinkages of monetary policy. The first of theseexplains economic activity (Gruen andShuetrim 1994). The main factor explainingthe Australian business cycle is overseasactivity, with real interest rates asserting someinfluence as well. The simplicity andtransparency of this equation is a major plus,but it has to be acknowledged that the problemof the simultaneous policy reaction has notbeen entirely overcome.7

That said, the equation fits the cycle prettywell (see Graph 5)8 and Graph 6 shows theimpact on GDP growth of a 1 per centincrease in the real cash rate, maintained fortwo years.9

Of course, this is a very simple equation.There are other models, of a ‘full-system’nature, which attempt to capture some of theparticular channels more explicitly. Twowell-known cases are the Murphy model, andthe Treasury’s TRYM model. We have somefamiliarity with these, though I am not goingto attempt a detailed exposition. These sortsof models see policy as operating through aseries of channels, rather like the ones Ioutlined earlier, including via the termstructure of interest rates to long rates, andfrom there on investment and the exchangerate. There are also asset/price wealthchannels.

7. The first-quarter lag of interest rates is omitted from this relationship because it has a positive sign in estimation,which the authors attribute to the policy reaction. But this policy reaction continues beyond a single quarter, andmust be confounded (to some extent) with the opposite (negative) relationship from interest rates to activity. Thismay be one of the reasons why this equation shows a relatively small impact over the first year or so following aninterest rate change. Given that interest rates characteristically rise quite early in the recovery process, there willinevitably be a longish period in which interest rates and activity are moving in the same direction. Unless themodel captures the forces explaining the underlying cycle pretty accurately, there seems a fair bit of room forslippage between cup and lip, in the estimation process.

8. A version of this equation using the two-year real interest rate works a little better: see earlier discussion on whichinterest rate is relevant.

9. An alternative approach to quantifying this link is to use the ‘sacrifice ratios’ estimated in some research work. InStevens (1992), a range of techniques was used to calculate the proportion of a year’s output which had to beforegone in order to reduce inflation permanently by 1 percentage point. It turned out that a loss of between 2 and3 per cent of a year’s GDP reduced inflation by about 1 per cent. In Debelle and Stevens (1995), the estimate wasa little higher – about 3.7 per cent. Using the relationship between output and interest rates in Graph 6, a 1 per centincrease in real interest rates for two years gives a cumulative loss of GDP of about 21/2 per cent over several years.Using the sacrifice ratio calculations, this would translate into a fall in inflation approaching 1 per cent. This is, ofcourse, what seems to have emerged from the average experience over a period of time. Any one particular episodemight be different from the average, especially in future, if the economy’s structure, and the monetary-policyregime, are changing.

Graph 4


26

Our impression of the structure andparameters of such models as these is that theresult of the thought experiment above – arise in short-term rates in real terms of1 per cent – looks broadly similar in terms ofits bottom line effect on activity. In Murphy,output falls, relative to the baseline, by abouthalf a percentage point. One interestingdifference is that the lags seem to be shorter –the full effect takes about a year and a half,but there is some effect virtually immediately.

One reason might be that Murphy hassubstantial exchange rate effects, which arevery fast-acting, whereas the single equationdoes not account for this channel separately(in fact, the authors couldn’t find aspecification including the exchange ratewhich they preferred).

I don’t want to get into a detailed discussionof these and other models. I am moreinterested in whether anything can be saidwhich encompasses the range of results. Tothe extent that there is some consensus fromthem, it seems to be that 1 per cent on cashrates might reduce the level of output belowwhat it would otherwise have been bysomething of the order of half a percentagepoint or so, within a period of time ranginganywhere from eighteen months to a coupleof years.

One might not think that this is much of aconsensus. But by the standards ofeconometric modelling, I suspect it is actuallya rather unusual degree of agreement. It isgranted that the models are calibrated overbroadly similar data sets, but that is rarelymuch guarantee of similar results from verydifferent modelling approaches. The fact thatthe lags are so difficult to pin down is a goodreminder of the difficulties of modelling aprocess which, in many ways, is far frommechanical or amenable to prediction.

Prices10

Three forces are working on prices – theoutput gap; import prices; and priceexpectations. The output gap will influenceinflation. This might be thought of in termsof the Phillips curve, with unemploymentaffecting wages, and this feeding through toprices. But it might just as well be thought ofas the direct effect of deviations from potentialGDP on inflation. In practice, it is likely to bea mix of both.

The top panel of Graph 7 tracks theinfluence of the output gap on inflation. Thetwo periods where inflation has come down

Graph 5

Graph 6

10. Murphy and TRYM also model the transmission to prices. In these models, prices respond quite quickly to achange in monetary policy because the exchange rate is assumed to respond quickly. The price of domesticproduction is largely determined by wages, which in turn are determined by the changes in employment whichreflect the change in monetary policy.


27

markedly (1983-1984 and 1990-1991)coincide with significant deviations of actualoutput from potential. Conversely, the rise ininflation in 1981-1982 is clearly associatedwith a period of pressure on capacity. This mayalso be true in 1985, although there was amore important force tending to push upinflation at that time – the 35 per cent fall inthe exchange rate. The same sort of patternscan be seen in the lower panel, relatingunemployment to inflation, via wages. The fallin inflation in 1983-1984 can be associatedwith a dramatic slowing in labour costs(reversing the sharp rise of the previous twoyears). Similarly, the reduction of inflation inthe early 1990s is associated with high levels

of unemployment and slow growth in labourcosts. The 1988-89 period shows a differentrelationship, with a small output gap andrelatively low unemployment, but nodeterioration in inflation (or increases in wagegrowth). This experience is a reminder thatthe output gap (or its analogue, theunemployment rate) is not the only factordriving inflation. But it is clearly veryimportant.

The other major short-term source of priceinfluence is via import prices. There are two‘legs’ to this linkage. First, from higher interestrates to the exchange rate. As noted earlier,such a linkage is hard to identify because ofthe simultaneous policy reaction. In the past,this has made it difficult to model the linkbetween interest rates and the exchange rate.11

Recent econometric work in the Bank hasidentified an effect from short-term interestdifferentials. This can be combined with thesecond ‘leg’ of the linkage, which is from theexchange rate to prices. Graph 8 shows thenet result of the linkage: a 1 per cent increasein the real cash rate, lasting for two years,would raise the exchange rate by around3 per cent and would trim 0.3 per cent offinflation, with a lag which reaches its peakeffect in ten quarters. Applying this to the last

Graph 7

Graph 8

11. Gruen and Wilkinson (1991) included an interest rate differential in their exchange rate equation, but (in theabsence of an identifiable short-term interest rate effect), they used long-term interest rates, whose linkage to thepolicy variable is more tenuous. This was also the approach of Blundell-Wignall, Fahrer and Heath (1993).


28

ten years or so. Graph 9 shows thecontribution of monetary policy to inflationvia the exchange rate channel.

environment do not enter the consciousnessof many of the professional observers, let alonethe general public. There was nocorresponding downward trend in bond rates,for example. The fall came right at the end.

This leads to the second point. The fall ininflation expectations in the early 1980srecession was short-lived, and the expectedrate of inflation went back to its earlier levelquite quickly, even though the actual rate ofinflation never regained the highs of 1981 and1982.Yet in the early 1990s recession,expectations came down quite quickly andhave stayed down, with the medianexpectation about half its earlier level. Whatwas the difference?

One difference was that in the latter episode,actual inflation not only failed to rise to itsprevious level, it didn’t rise at all for aboutthree or four years. That helped to cement lowexpectations.

The other factor which must have made adifference is the very strong and clear focusof monetary policy on sustaining low inflationover recent years. That objective had alwaysbeen present, of course. But it has beenstronger over recent years than at any othertime for a generation. (This coincided with atime when policy has clearly had the capacityto use its instrument in an effective way,unhampered by institutional arrangementslike fixed exchange rates and administeredinterest rates which often frustrated theintentions of policy in other periods.) Theprocess of easing interest rates through1990-93 helped to get recovery in activitygoing – the cyclical dimension of policy – butit was conducted in a measured and carefulway, with an eye to maximising the chancesof sustained low inflation. The Bankalso began during 1993 to articulate amedium-term inflation goal: not as narrowand confining as some of the (supposedly)hard-edged targets in other countries, but inpractice perhaps not all that different. Everyinformed observer now knows the intentionto keep to ‘2-3’ over time.

So it seems to be that cyclical episodes offalling actual inflation offer the mainopportunities to get inflation expectations

Graph 9

Graph 10

The third aspect of price determination –the role of price expectations – is morenebulous and harder to quantify. Two thingsare clear from the Melbourne Institute series(Graph 10 ).The first is that falls in expectedinflation seem to occur only when there is arapid fall in actual inflation and the associatednews. These are, furthermore, connectedinvariably with a cyclical episode. It is worthnoting that there was a clear downward trendin inflation between 1980 and 1990,interrupted by the effects of the exchange ratedepreciation in the middle. As so often is thecase, these gradual changes in the economic


29

down. But the atmospherics of monetarypolicy – what policy-makers state as theirobjectives, and the way in which policyadjustments are timed and motivated – needto be geared to seizing that opportunity.

What about the upswing of the cycle? Thatsame focus on containing medium-termexpectations needs to be maintained. Policyhas to be tightened early, ideally before higherinflation actually shows up in consumer prices.We take some satisfaction in having done that,with the first tightening almost a year beforethe first clear evidence of a pick-up inunderlying inflation came through (in theJune 1995 CPI). The interest rate moveswere highly public, and clearly motivated bythe need to ease spending to a moresustainable pace in the interests of sustainingthe medium-term growth and inflationperformance we are looking for.

It is too early to tell yet how successful wehave been in controlling inflation expectationsduring this upswing. The early evidence is thatthere has been relatively little deterioration inconsumer expectations so far. Economists’forecasts show some increase (though in manyinstances by less than the official forecasts for1995/96 envisaged). They then seem to expecta fall back to close to 3 per cent in thefollowing year. Bond rates still seem toembody too much inflation, however. As I say,it is too early to tell. But you can see that thisarea of the transmission mechanism isimportant to the successful medium-termconduct of policy.

The Role of Credit andMonetary Aggregates

In examining the transmission process, thereis no special role for the credit or monetaryaggregates. Partly this reflects a priori viewsabout the way the world works. Monetarypolicy doesn’t work by restricting or ‘rationing’the reserve funds available to the banks and

so limiting the supply of credit via balancesheet constraints: it works by way of changingthe price of borrowing, shifting borrowersalong their borrowing demand curve. So themoney multiplier process (so beloved oftextbook writers) has no relevance to policytransmission.12 Nor does the notion thatmonetary policy operates by expanding themoney supply (or base money) and this excesssupply bids up demand for goods and services(and their prices) as people attempt to get ridof their excessive money balance.

Beyond this kind of a priori reasoning, therehas also been a break-down of any closeempirical relationship between credit (or for thatmatter, any of the monetary aggregates) andnominal income. This is not to deny that theremay still be quite a bit of information in thecredit (or monetary) aggregates, so that theycan be used as information variables. This wouldbe quite consistent with the transmissionchannels outlined above – credit and nominalincome will be quite closely related, with thedirection of causation being from nominalincome to credit: stronger growth of nominalactivity causes a greater demand for credit. Soit would not be at all surprising to find a closecorrelation between the two, and indeed it mightbe hard to tell, at times, just what was causingwhat. Some monetary economists have soughtto demonstrate that there is a stable leadingrelationship in the credit or monetaryaggregates, as part of a well-intentionedquest to get the Reserve Bank back onto thestraight-and-narrow of a simple operationalrule, such as is provided by credit or monetaryaggregates. As you can imagine, we ourselveshave searched long and hard to find such arelationship, because it might make our taskeasier if we had a reliable intermediate target(see de Brouwer, Ng and Subbaraman (1992)).In our judgment, however, no such reliableleading relationship exists. The most thatcan be said is that business creditmay at times lead business investment(Blundell-Wignall et al. 1992) – and even thisdoes not appear to be the case in the present

12. In the earlier, regulated financial system, there were times when it was reasonable to think of an increase in moneysupply being exogenous i.e. policy induced. For example, unfunded budget deficits or unsterilised foreign exchangecould leave excess liquidity in the financial system. But this no longer has relevance in the deregulated world.


30

upswing. In the lesser role – as an indicatorrather than an intermediate target – the creditaggregate can serve a useful role. We look at it(and the monetary aggregates) carefully. Theday may come when they can be elevated to amore important role, if the stability andpredictive power of the credit/nominal activityrelationship becomes sufficiently reliable. Forthe moment, however, credit is just one, amonga number of things, which we monitor.

A Perspective

We can describe the detailed channels oftransmission, and put approximatemagnitudes on the links between theinstrument and objectives. But theeffectiveness of monetary policy, and thepower of each of the individual channels, willdepend very much on the specific climate ofthe time. I want to draw the pieces togetherby looking at the experience of the last decade,to see what lessons can be distilled on the waymonetary policy works.

As we look for the effect of monetary policyon inflation, it is common to think of the 1980sas a poor performance in terms of pricestability. But the clear peak of inflation was inthe mid 1970s, with each subsequent peak(and trough) lower than the one before(Graph 11). The price stability improvement

of the past decade is more noteworthy whenthe events of the period are taken intoconsideration (the 35 per cent fall in theexchange rate in the mid 1980s and the assetprice boom of the late 1980s). Not only wasinflation reduced substantially, but theinflationary pressures of exchange ratedepreciation were absorbed, to the extent thatthe real exchange rate is more than 25 per centlower now than in the first half of the 1980s.

This inflation improvement cannot, ofcourse, be attributable solely to monetarypolicy. The 1982 wage freeze, the subsequentAccords and the wage/tax trade-offs allcontributed. The Accord and the wage/taxtrade-offs in the late 1980s were important –together with high interest rates – in ensuringthat there was no significant slippage of eitherwages or prices despite the very rapid growthof demand at the time, and despite thepotential contagion from asset price inflation.The sharp slowing of the economy in the early1990s was an environment in which progresscould be made in lowering actual andexpected inflation. This is the period whenmonetary policy probably made its greatestcontribution. The depth of this slowing ineconomic activity was similar to 1982/83, butsomething in the environment made moreimpact on price expectations (as reflected inGraph 10). There was, by this stage, a moreprominent commitment to price stability,clearly articulated by the Bank. We need a bitmore historical perspective to judge thisperiod properly, and we are certainly notcomplacent about the task of maintainingprice stability. But if, as seems likely, thispainful period has ushered in a sustainedperiod of price stability, then in time peoplemay come to judge it more positively.

How did this inflation reduction take place?The central theme in any story of the sustainedreduction in inflation is: ‘how were priceexpectations lowered?’ To a large extent, thishad to be done the hard way: priceexpectations are largely ‘backwards looking’,so can be changed only by the economyoperating below capacity, with the reductionin inflation that this causes feeding through(with a lag) to lower price expectations. The

Graph 11


31

painful process can be (and was) helped inseveral ways. ‘Circuit breakers’ – in the formof a wage freeze. Accords, wage/tax trade-offs– have all allowed inflation to be eithercontained or reduced, and this has fed intolower price expectations. This may be thereason why Australia seems to haveexperienced a comparatively low ‘sacrificeratio’ (the amount of output which has to beforegone for any given reduction in inflation(Debelle 1994).

In this process of inflation reduction, theexchange rate can also play an important rolein redistributing an inflation impulse over thecourse of the cycle, levelling out the peak andavoiding an adverse shift in price expectations.It can also be helpful in buffering the impactof terms of trade changes (Gruen andShuetrim 1994). The exchange rate, however,has its limitations: it cannot fundamentallychange the sacrifice ratio, nor consistentlyanchor price stability if the domestic balanceis out of kilter. Pushing up the exchange rateto obtain price stability is usually ‘borrowingfrom the future’, which has to be paid backlater as the exchange rate returns to itsmedium-term equilibrium. That said, theappreciation of the Australian dollar was animportant factor in the reduction of inflationand price expectations in the early 1990s.

To identify a separate role for central bankcredibility in this process of inflation reductionis harder, but to ignore it would be to miss apotentially important influence on priceexpectations. While there may be littleimmediate dividend in professing – or evenlegislating – a commitment to price stability,expectations about future monetary policy canbe important in holding onto low inflationonce it has been established. If expectationsof future inflation ratchet up when there is apick-up in inflation, the job of maintaininglow inflation without a significant increase inunemployment will be more difficult. Incontrast, if price and wage setters view anincrease in inflation as only temporary, theywill not ratchet up their expectations of futureinflation. With lower inflation expectations,wages and prices pressures will be reducedfor any given level of demand in the economy.

Finally, a word on lags. The ‘long andvariable’ lags that Friedman warned us aboutare clearly still with us. In 1988/89, monetarypolicy seemed to take an inordinate time towork: in 1994, its impact seemed quite quick.In 1985, very high interest rates were followedby a mild slowing in 1986, whereas in 1989,(slightly) lower interest rates were followed bya sharp slowing in activity. The problem oflags takes some people in an unhelpfullynihilistic direction, in which they believe thatmonetary policy is so imprecise and slow inits operation, that it needs to be put on somekind of automatic pilot. This view is oftenbased on the misleading interpretation thatnothing happens during the lag period (oftendescribed as being 4-6 quarters) .This nihilismis reinforced by the observation that, for allour efforts, the business cycle is still with us.Looking back on a cycle and trying to assess,ex post, whether monetary policy operated forgood or ill, we won’t be able to identify theseparate impact of monetary policy with anyprecision. The ‘counter-factual’ – what wouldhave been – is always unknowable. In thesecircumstances, some people conclude thatmonetary policy is a feeble and unreliablereed, too difficult to operate effectively.

If there is a danger that monetary policy willbe seen as ‘too difficult’, there is also a riskthat too much will be expected of it or, at least,that its success or failure will be judged againstan impossibly-high standard: it can’t cure thebusiness cycle; it can’t reduce inflationcostlessly; and it can’t be operated withsurgical precision. For all the imprecision,monetary policy still has a central role to play.The question is not whether we know enoughabout policy to achieve perfect price stabilityand end the business cycle. The issue is: canpolicy contribute to buffering the swings ofthe business cycle and keeping a good degreeof price stability? The record – imperfectthough it is – speaks for itself: low inflationhas been achieved, and activity is not far frompotential. Could we do better? Maybe, butsimple rules cannot capture the complexityof the economy. Nor, for that matter, cancomplex models fully capture the ephemeraland non-mechanical nature of the linkages.


32

References

Access Economics (1992), Access Economics Murphy Model – The Model in Detail, Version 2.1.Blundell-Wignall, A., J. Fahrer and A. Heath (1993), ‘Major Influences on the Australian Dollar

Exchange Rate’, in A. Blundell-Wignall (ed), The Exchange Rate, International Trade and theBalance of Payments, Reserve Bank of Australia, Sydney, pp. 30-78.

Blundell-Wignall, A., P. Lowe and A.Tarditi (1992), ‘Inflation, Indicators and Monetary Policy’,in A. Blundell-Wignall (ed), Inflation, Disinflation and Monetary Policy, Reserve Bank ofAustralia, Sydney, pp. 249-298.

Debelle, G., (1994), ‘The End of Three Small Inflations: Australia, New Zealand and Canada’,Chapter 2, PhD thesis, MIT.

Debelle, G. and G.R. Stevens (1995), ‘Monetary Policy Goals for Inflation in Australia’, ReserveBank of Australia Research Discussion Paper No. 9503.

Duguay, P. (1994), ‘Empirical Evidence on the Strength of the Transmission Mechanism inCanada: an aggregate approach’, Journal of Monetary Economics, 33(1), pp. 39-61.

de Brouwer, G., I. Ng and R. Subburaman (1993), ‘The Demand for Money in Australia’sNew Test of an Old Topic’, Reserve Bank of Australia Research Discussion Paper No. 9314.

Downes, P. (1995), ‘An Introduction to theTRYM Model – Applications and Limitations’,paper presented to the 1995 IFAC/IFIP/IFORS/SEDC Symposium on Modelling andControl of National and Regional Economies, Gold Coast, Queensland Australia, 2-5 July.

Fazzari, S., G. Hubbard and B. Petersen (1988), ‘Financing Constraints and CorporateInvestment’, Brookings Papers on Economic Activity, l, pp. 141-195.

Gertler, M., and S. Gilchrist (1991), ‘Monetary Policy, Business Cycles and the Behaviour ofSmall Manufacturing Firms’, NBER Working Paper No. 3892.

Gruen, D.W.R. and G. Shuetrim (1994), ‘Internationalisation and the Macroeconomy’ inP.W. Lowe and J. Dwyer (eds) International Integration of the Australian Economy, ConferenceProceedings, Reserve Bank of Australia, Sydney, pp. 309-363.

Gruen, D.W.R. and J. Wilkinson (1991), ‘Australia’s Real Exchange Rate – Is It Explained bythe Terms of Trade or by Real Interest Differentials?’, Reserve Bank of Australia ResearchDiscussion Paper No. 9108.

Lowe.’P (1995), ‘The Link Between the Cash Rate and Market Interest Rates’, Reserve Bankof Australia Research Discussion Paper No. 9504.

Macfarlane, I.J. and W.J. Tease (1989), ‘Capital Flows and Exchange Rate Determination’,Reserve Bank of Australia Research Discussion Paper No. 8908.

Mills, K., S. Morling and W.J. Tease (1994), ‘The Influence of Financial Factors on CorporateInvestment’, Reserve Bank of Australia Research Discussion Paper No. 9402.

Murphy, C.W. (1995), ‘MM2’, paper presented to the 1995 IFAC/IFIP/IFORS/SEDCSymposium on Modelling and Control of National and Regional Economies, Gold Coast,Queensland Australia, 2-5 July 1995.

Rankin, R.W. (1992), ‘The Cash Market in Australia’, Reserve Bank of Australia ResearchDiscussion Paper No. 9214.

Taplin, B. et al. (1993), ‘Documentation of the Treasury Macroeconomic (TRYM) Model ofthe Australian Economy’, paper presented at the Treasury Conference on The TRYM Modelof the Australian Economy, June.

There seems to be no substitute forgrappling with the changing, impreciserelationships between the monetary policy

instrument – short-term interest rates – andthe final objectives.


33

Tease,W.J. (1993), ‘The Stockmarket and Investment’, OECD Economic Studies, No. 20, Spring.Stiglitz, J.E. and A.Weiss (1981), ‘Credit Rationing in Markets with Imperfect Information’,

American Economic Review, 71(3), pp. 393-410.

the monetary policy transmission process: what do we know ... · the monetary policy transmission...

Documents