Monetary policy has been in unchartered territory since the global financial crisis of 2007-2008. Interest rates in the Group of Seven (G7) countries have been cut by the central banks to zero or near zero since 2008 and have remained at that level until now. Besides the lowest level of interest rates, G7 central banks have engaged in massive financial asset and government bond purchases to continue to increase money supply at the zero bound while rescuing financial institutions which were impacted adversely by the crisis.
New regulations have been put into place with the intent of preventing future such crises and to ensure the solvency of financial institutions should a crisis occur again. Stress tests of systemically important financial institutions have concluded that the financial institutions are better prepared for any future crisis.
In spite of extraordinarily accommodative monetary policy and new regulatory regimes to contain the possibility of crises again, economic recovery has been slow and gross domestic product (GDP) growth rates have been, at best, moderate and, at worst, modest with low potential growth rates.
The Japanese economy remains mired in low or recessionary growth, continuing to be in an economic condition that began with the lost decade of the 1990s when its real estate bubble burst. It is now feared that, absent unconventional monetary policies, looking forward, the other G7 countries could face the same fate as Japan.
It has been argued that the interest rate sensitivity of G7 economies has gone down because of the large service sectors in G7 countries which are less sensitive to interest rate changes compared to agricultural and industrial sectors. It is unclear if the G7 economies are more sensitive to interest rates when interest rates are on the rise during monetary tightening than they are during monetary easing. In the United States consumer spending on durable goods and on residential fixed investment after the crisis has also been found to have become less sensitive to decreasing interest rates because consumers have withheld spending to make their debt-to-income ratios better. The question arises, however, as to why ever lower interest rates are being expected by market participants before investment and consumer spending can fully recover? Expectations could provide an answer.
Though the conduct of monetary policy has been discounted as a reason for muted interest rate sensitivity of the economy since 1984 in the United States, it must be remembered that the expectation of preemptive easing before economic downturns and especially during crises and preemptive tightening to avert higher levels of inflation has become the norm since the coming of the Greenspan Fed in 1987. Market participants expect the central bank to keep cutting interest rates until recovery indicators surface and, therefore, consumers hold back spending on big ticket items such as durable goods and residential fixed investment, and businesses hold back on capital spending waiting for lower interest rates. Likewise, as inflation begins to rise, with the expectation that the central bank will raise interest rates, market participants will borrow and spend before rates rise further.
Monetary policy response and, in particular, central bank signaling of the health of the economy, therefore, plays a critical role in setting and managing the expectations of consumers and businesses.