Monetary Policy Transmission: What Could Go Wrong?
When ease-of-credit access policies are enacted, such as what the Bank of Botswana has been doing, structures should be in place to ensure that funds are put to productive use and that government regulations are also pro-investment
For any country, economic conditions are rarely ever in a calm state. The economy can be shrinking, sluggish or growing too fast. As such, governments and monetary authorities in the form of central banks have a set of tools that they can employ to reverse adverse economic conditions or accelerate a desired course of action and outcome.
Monetary policy tools are used by central banks to affect the amount of money supply in the economy, and consequently the available funds that can be advanced by commercial banks to borrowers in the form of credit. Accommodative or expansionary policies are pursued with the view to increase the supply of money in the economy, while contractionary policies are used to reduce or restrict credit growth. The key monetary policy tools include benchmark rates, open market operations, and the primary reserve requirement. Whichever instrument is employed, the goal is to manipulate the cost of accessing money to economic participants.
On the fiscal policy side, governments alter their spending capacity and tax policies with the main aim of affecting the rate of economic growth. To arrest high economic growth, contractionary policies of either reducing government spending or raising taxes are employed, whereas expansionary fiscal policy actions are taken to boost a sluggish economy. Our focus will be on monetary policies tools, with emphasis on their application during the COVID pandemic, and the unintended consequences of these actions.
Over the past 12 months, global economies experienced sharp declines in growth rates as emergency pandemic measures like lockdowns, restricted business operations and general negative business outlook reduced both the demand for goods and services and production capacities of many industries. As a result, key indicators like Gross Domestic Product, employment and inflation plummeted to undesirable levels. Credit growth dropped in commercial banks’ balance sheets as demand for funding dried up and banks themselves hoarded cash in anticipation of uncertain liquidity and capital conditions as deposit inflows reduced as well.
To address these challenges, central banks quickly moved to employ accommodative monetary policies, with the aims of increasing the volume of money available in the economy for credit creation, shore up commercial banks’ balance sheets in order to reduce their risks of financial distress and potential failures, and even more importantly, to restore confidence in the entire economic ecosystem. Central banks reduced their benchmark interest rates which serve as reference rate for all other rates. By law commercial banks are required to reduce their cost of lending by a similar magnitude. Accommodative open market operation practices involve the central bank embarking on sustained purchases of its securities from commercial banks, enabling commercial banks to have more cash on their balance sheets which they can then use to extend more credit to borrowers. Finally, the monetary authority can reduce the primary reserve requirement – which is the proportion of commercial bank deposits kept with the central bank. A lower reserve requirement allows commercial banks to have excess cash to lend.
Despite the best intentions of central banks, there are several factors that can nullify a policy action. With regards to reduced costs of lending, this often leads to shrinking profit margins for commercial banks and increased adverse selection risks as more previously poor creditworthy borrowers apply for credit. The response from banks would be to introduce more stringent lending criteria, in the process defeating the central bank’s goal of increased credit access.
The volatility of economic variables often results in premature abandonment of policy measures. A case in point is how, after committing to an accommodative policy stance of continued bond purchases until at least the end of 2021, there is indication that the Bank of Canada might be backtracking on the programme as the economy appears to be recovering faster than anticipated and rising inflation fears taking centre stage.
A policy stance is only as strong as the reliability and perceived strength of its executer. Essentially, monetary policy actions should be clear enough to enhance confidence and promote calmness in the system and yet vague enough to maintain an aura of mystique. This is particularly relevant for policies which are employed to target specific economic variables like inflation or currency exchange rate levels. Any deviation from plan or perceived weakness can expose the monetary authority to actions of speculative market participants, as was the case with the Bank of England in 1992.
Finally, for monetary policy stance to be effective in transmission, it has to be supported by a corresponding or at least non-contradictory fiscal policy. For example, when ease-of-credit access policies are enacted, there has to be structures in place to ensure that funds are not only put to productive use but that government regulations are also pro-investment. With business and movement restrictions in place, there will be no incentive for companies to apply for credit as productive capacity and consumer demand are low.