16 October 2016

Vox EU: Keeping policy rates persistently low - Implications for the monetary transmission mechanism

Central banks responded to the financial crisis by cutting policy rates to prevent deflation and curb the decline in economic activity, but these responses have been anything but temporary. Is the sticky price channel still relevant in an environment of persistently low rates?

This column, authored by Carlos Garriga, Finn Kydland and Roman Šustek, explores whether the sticky price channel is still relevant in an environment of persistently low rates. Although the effectiveness of the sticky price channel is limited, monetary policy instead transmits through mortgage debt. The recent period of low rates and low inflation has redistributed income and consumption from savers to mortgage borrowers.

In the wake of the financial crisis of 2008 and 2009, central banks have cut policy rates to near zero in order to contain the decline in economic activity and prevent deflation. Eight years on, nominal interest rates are still at low levels, inflation is well below central banks’ targets, and output growth is muted. The narrative of policymakers justifying such policies also remains broadly unchanged.

According to the existing paradigm, central banks have leverage over the real economy because firms find it costly to adjust prices in response to temporary changes in monetary policy. But is this channel still effective when monetary policy is persistent? Or should we be looking at other channels? We argue that the sticky price channel loses its potency when interest rates are kept at the same level for a long time. Instead, monetary policy starts to transmit through long-term nominal debt contracts such as mortgages or instalment loans. However, the real effects working through this channel in a traditional macro model are mainly redistributive.

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Policy implications

Our findings have clear implications for the current policy environment, in which nominal interest rates have been kept at low levels for almost a decade. The purpose of such policies was to stimulate aggregate economic activity. According to our model, the initial cut in policy rates may have fulfilled this objective, to the extent it was expected to be temporary, but the subsequent policy of keeping rates low for a substantial period of time more likely led to income and consumption redistribution than to the desired aggregate effects. As inflation followed nominal interest rates to similarly low levels, based on our model, we can infer that lenders in predominantly FRM countries (the US, Germany, France, Belgium) gained at the expense of borrowers due to persistently low inflation rates, while in predominantly ARM countries (most other countries) borrowers gained at the expense of lenders due to persistently low nominal interest rates.

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