Losing traction? The real effects of monetary policy when interest rates are low

BIS Working Papers  |  No 983  | 
25 November 2021
by Rashad Ahmed, Claudio Borio, Piti Disyatat and Boris Hofmann
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  |  35 pages

Summary

Focus

Interest rates in many countries have been exceptionally and persistently low for over a decade now. Despite these very low rates and aggressive monetary policy easing, the strength of the economy has been disappointing. We ask whether this outcome implies that monetary policy has become less effective in stimulating aggregate expenditure.

Contribution

Based on a panel of 18 advanced economies starting in 1985, we examine whether aggregate demand becomes less responsive to changes in the monetary policy stance ("shocks") when interest rates are low and whether its response weakens over time when they stay low. In doing so, we control for confounding factors, notably the state of the business cycle, debt levels and a possible trend decline in equilibrium interest rates. 

Findings

We find that monetary transmission to economic activity is substantially weaker when interest rates are low. We also find evidence that the effectiveness of monetary policy wanes the longer interest rates stay low. As a result, monetary policy trade-offs may have become more challenging.

Abstract

Are there limits to how far reductions in interest rates can boost aggregate demand? In particular, as interest rates fall to very low levels, does the effectiveness of monetary policy in boosting the economy wane? We provide evidence consistent with this hypothesis. Based on a panel of 18 advanced countries starting in 1985, we find that monetary transmission to economic activity is substantially weaker when interest rates are low. The results hold even when controlling for potential confounding non-linearities associated with debt levels and the business cycle as well as for the trend decline in equilibrium interest rates. We also find evidence that the effectiveness of monetary policy wanes the longer interest rates stay low. These findings suggest that the observed flattening of the Phillips curve has gone hand in hand with a corresponding steepening of the IS curve. Monetary policy trade-offs may have become more challenging.

JEL classification: E20, E52, E58.

Keywords: monetary policy, low interest rates, monetary transmission mechanism.