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September 12, 2023 | Central Banks Offer No Free Lunch

Danielle Park

Portfolio Manager and President of Venable Park Investment Counsel ( Ms Park is a financial analyst, attorney, finance author and regular guest on North American media. She is also the author of the best-selling myth-busting book "Juggling Dynamite: An insider's wisdom on money management, markets and wealth that lasts," and a popular daily financial blog:

The San Fransisco Federal Reserve published its latest economic letter last week, entitled Does Monetary Policy Have Long-Run Effects? The conclusions are clear: loose monetary policy does not raise long-run economic potential while the eventual tightening of policy reduces economic output for a decade and beyond. We have entered the payback decade:

Analyzing cross-country data for a set of large national economies since 1900 suggests that tight monetary policy can reduce potential output even after a decade. By contrast, loose monetary policy does not appear to raise long-run potential. Such effects may be important for assessing the preferred stance of monetary policy.

… in response to a 1% increase in interest rates, output would be about 5% lower after 12 years than it would otherwise be. To provide some context for these numbers, consider some data for the United States. A 5% decline in the output trend caused by the monetary intervention relative to the pre-intervention trend would reduce an individual’s income by $3,000 in today’s dollars on average.

…If raising interest rates can have such costs in terms of the longer-run capacity of the economy, what about lowering rates: can a central bank boost the economy’s long-run potential with more accommodative monetary policy through lower interest rates?

Figure 2 (below) shows that this is not the case. When we separate our interest rate experiments into those that resulted in rate hikes versus those that resulted in lower interest rates, we see that there is no free lunch. That is, a central bank might not be able to undo the long-run effects on the economy’s potential by running the economy hot. The blue line shows that lower interest rates have mostly temporary effects that vanish after a few years, as traditional theories predict. However, the red line reinforces the results from Figure 1 that show an increase in interest rates casts a long shadow on the economy.

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September 12th, 2023

Posted In: Juggling Dynamite

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