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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 show no signs of regret as they approach the end of their tightening cycles. Even if they go too far and end up crushing the economy, central banking lore suggests that any short-term pain should eventually fade. It’s a comforting thought, but one that is increasingly being challenged.
Conventional wisdom says that while monetary policymakers can impact an economy in the short term, over longer periods, their influence wanes. As expectations adjust, attempting to stimulate the economy with easy money will result in tears and inflation. Bank of England deputy governor Ben Broadbent explained last October, “One cannot permanently enrich a country simply by doling out more banknotes.” Real effects require real changes.
Economists have long questioned this core assumption. In recent years, sluggish productivity growth has fueled suspicions that policymakers are naive about their own power. Luca Fornaro of the Barcelona School of Economics and Martin Wolf of the University of St Gallen theorized this year that higher interest rates discourage innovation and curb potential growth, raising the cost of capital and dampening expected demand.
Proving something with data is more challenging than demonstrating it in a model. This is especially true when data is scarce and uncertain. Central bankers adjust interest rates in response to the shifting macroeconomy. So how can one be certain that weak growth a decade later is truly caused by monetary policy and not a reaction against something else?
A couple of recent papers attempt to provide answers. The first, by three economists from the Federal Reserve Bank of San Francisco, examines countries that historically pegged their exchange rates. These economies effectively absorb monetary policy shocks from overseas, making subsequent changes more confidently attributed to 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%, the capital stock by 4%, and gross domestic product by 5%. Interestingly, the results are asymmetric, with tight money having a negative impact while easy money does not stimulate the economy in the long run. They also suggest that other studies using different methods would have found smaller long-term effects of monetary policy if only they had looked.
Support for the idea that monetary contractions limit investment in research and development, hindering growth, comes from another paper presented at Jackson Hole. Yueran Ma of the University of Chicago and Kaspar Zimmermann of the Frankfurt School of Finance & Management find that three years after a one percentage point rise in interest rates, research and development spending falls by 1-3%, venture capital investment falls by a quarter, and patenting and innovation fall by 9%.
Some may argue that if there is less money available for speculative investments like cryptocurrencies, that’s not necessarily a bad thing. Low interest rates can even hinder growth by promoting resource allocation to frivolous ideas. However, Ma and Zimmerman find that important technologies mentioned in companies’ earnings calls, such as cloud computing and electric vehicles, are particularly sensitive to rising interest rates.
Questioning old assumptions is healthy, and economists should engage in it frequently. As evidence accumulates, central bankers should also consider its implications for policy. Perhaps, for example, they should think twice about aggressively curbing inflation if it could have long-term consequences for productivity growth.
For now, the appetite to do anything other than combat inflation is almost nonexistent. Former Fed vice-chair Donald Kohn commented at Jackson Hole that the Fed’s contribution to innovation is “to achieve the dual mandate.” Being predictable and stable provides companies the certainty they need to invest. Once you start considering side effects, where does it end? What if your interest rate decisions lead to a financial crisis?
Monetary policy is a blunt tool, and the more tasks it is assigned, the less effective it becomes at each one. If raising interest rates derails investment and innovation, others will be left to clean up the mess.
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