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Complaining that central bankers are squeezing borrowers is a bit like grumbling that weight-loss drugs are making your face look gaunt. Looking pinched is part of the process. Officials at the Federal Reserve, the Bank of England and the European Central Bank are certainly showing no signs of regret as they approach the end of their tightening cycles. Even if they have gone too far and end up crushing the economy, central banking lore is that any short-term pain should eventually fade. A comforting thought — but one that is increasingly being challenged.
Conventional wisdom is that while monetary policymakers can wind an economy up or down over the short term, over longer periods they are pretty much impotent. As expectations adjust, trying to juice up the economy with easy money will end in tears and inflation. “One cannot permanently enrich a country simply by doling out more banknotes,” explained Bank of England deputy governor Ben Broadbent last October. If you want real effects, you have to change real things.
Over the decades, economists have poked at this core assumption. In the 2010s, sluggish productivity growth refuelled suspicions that policymakers were being naive about their own power. Luca Fornaro of the Barcelona School of Economics and Martin Wolf of the University of St Gallen theorised this year that higher interest rates discouraged innovation and curbed potential growth, by raising the cost of capital and dampening expected demand.
Showing something is possible in a model is easier than proving it with data. That is particularly true when there isn’t much data, and what is available is riddled with uncertainty. Central bankers change interest rates in response to the shifting macroeconomy. How, then, can one be certain that weak growth a decade later is really caused by monetary policy, and not whatever it was reacting against?
A couple of recent papers have had a go. The first is by three economists attached to the Federal Reserve Bank of San Francisco, and studies countries that historically pegged their exchange rates. Those economies in effect absorb monetary policy shocks from overseas. That means one can be more confident that any subsequent changes are independent of developments at home.
The researchers estimate that 12 years after a one percentage point increase in interest rates, total factor productivity is curbed by 3 per cent, the capital stock by 4 per cent and gross domestic product by 5 per cent. Interestingly, the result is asymmetric; while tight money hurts, easy money does not appear to stimulate the economy in the long run. And they work out that other studies using different methods would have found (smaller) long-term effects of monetary policy if only they had looked.
The line that monetary contractions curb investment in research and development, which hampers growth, is supported by another paper by Yueran Ma of the University of Chicago and Kaspar Zimmermann of the Frankfurt School of Finance & Management, which was presented at Jackson Hole. They find that three years after a one percentage point rise in interest rates, research and development spending falls by between 1 and 3 per cent, venture capital investment falls by a quarter and patenting and innovation falls by 9 per cent.
One might scoff that if there is less money around to chase crypto crazes, that is no bad thing. Low interest rates could even hold back growth by encouraging the misallocation of resources to silly ideas. But Ma and Zimmerman find that the important technologies often mentioned in companies’ earnings calls, such as cloud computing and electric vehicles, are particularly sensitive to rising rates.
Questioning old assumptions is healthy, and economists should do lots of it. As evidence builds, central bankers should also ask what it might mean for policy. Perhaps, for example, they should think twice about crushing inflation aggressively if there could be long-term consequences for productivity growth.
For now, the appetite to do anything other than beat down inflation is close to nil. Donald Kohn, former Fed vice-chair, commented at Jackson Hole that the Fed’s contribution to innovation was “to achieve the dual mandate”. Being boring and stable gives companies the certainty they need to invest. Once you start considering side-effects, where do you stop? What if your interest-rate setting stores up a financial crisis?
Monetary policy is a blunt tool, and the more things it is asked to do, the worse it will perform at each. For now, if hoiking up interest rates derails investment and innovation, the mess will be left to others to tidy up.
