Economic Scarring - Monetary Style
Monetary policy is there for a specific purpose, namely to regulate demand. But traditional theory is that monetary levers have no lasting impact, ie they do not affect potential growth and have transitory effects rather than permanent ones (Figure 1). This view is being challenged particularly against the backdrop of the very sizeable and speedy policy tightening seen globally, raising the question that monetary policy may cause not just economic bruising but economic scarring. Indeed, the issue that monetary policy may have longer-term and lasting effects was actually discussed in a paper at the recent Fed Symposium at Jackson Hole. This paper concluded that monetary policy has a substantial impact on innovation activities and hence productivity. Other research goes further in suggesting sharp monetary moves do not have symmetric effects, so that while tighter policy has a clear impact, easing policy does not stimulate the economy in the long run. Such effects, especially if they are so contrasting, may be important for assessing the preferred stance of monetary policy. Thus we examine some of the conclusions more closely.
Figure 1: Assessing Shocks
Conventional Theory Being Challenged
None of the likes of the Fed, the BoE and/or ECB are showing signs of regret as they approach the end of their respective tightening cycles. Central banking thinking is that any short-term pain should eventually fade, this very much reflecting long-held economic orthodoxy.
Conventional economy theories typically assume that monetary policy is neutral in the long run, at least in terms of growth.In other words, central bank actions do not have indefinite real economic impacts. Trying to stimulate an economy on anything but a short-term basis will instead end in inflation. In order to achieve real effects, you have to change real things.
What Drives Potential?
First some perspective. Broadly speaking, three factors determine an economy’s potential growth rate; the first two are how much capital is available alongside how much labor there is to operate that capital. The third factor is total factor productivity (TFP), which is how skillfully stocks of capital and labor can be combined to obtain more output. All of which means that monetary policy only has short-term consequences as it does not affect any of the three factors determining potential growth.
But this view is being challenged, suggesting monetary policy can and does affect TFP and thus potential growth.Other research even goes as far as to suggest that monetary tightening, by reducing investment and future productivity, may actually increase inflation in the medium run.
Scarring - Monetary Style
This verdict is something we have touched on before when we looked at the issue of economic scarring.This was precipitated by assessing how the recent sizeable contraction that some economies have had in recent years (mainly due to the pandemic) may have more persistent negative effects. Academic research is still threadbare when it comes to how scarring is caused, and the circumstances under which it becomes more probable, even though these are critical questions for both policymakers and researchers. But more recent research does increasingly suggest that while the potential for scarring is independent of whether the contraction was caused by a financial crisis, a sharp monetary policy tightening to combat high inflation or a supply shock caused by steep increases in energy prices.But against the backdrop of sharp and in some cases unprecedentedly large monetary tightening it is the question of whether this is not only weighing on growth but also on potential growth.In other words does a monetary policy shock have a permeant economic effect or a temporary one (Figure 1).
Are Monetary Moves Symmetric?
One key and central issue is that higher interest rates will discourage innovation and curb potential growth, by raising the cost of capital and dampening expected demand. As Keynes suggested in the long-run we are all dead, implying that it is difficult to assess long-terms consequences as the long-term is a series of successive short-terms. But the array of research we feature here does try and answer this.It varies from estimating that 12 years after a one percentage point increase in interest rates, total factor productivity is curbed by 3 per cent and gross domestic product by 5 per cent to other conclusions that three years after a one percentage point rise in interest rates, R&D spending falls by between 1 and 3 per cent. Perhaps more notable is the possibility that such results are asymmetric; so that while tighter policy has a clear and detrimental impact, easing policy does not stimulate the economy in the long run.
This is far from widely thought though, with most other research, actually suggesting the same-sized impact but in reverse of a policy easing to that of tightening. It is also suggested that perhaps it is not the level of policy that is as important as the change and speed of change.It is also thought too that low interest rates could even hold back growth by encouraging the misallocation of resources
As suggested above, while this monetary scarring issue is getting more attention, it is not something that has hit the radar screen of current central bankers. But the risk is that extensive, if not excessive monetary tightening has long-run effects.Perhaps central bankers are comforted by the fact that it will be their successors as policy makers who may have to suffer the consequences.