How can you use monetary policy to stabilize the business cycle?

Monetary policy has been distorted since the financial crisis and its policy impact transformed. Typically the “free market” sets all US TSY rates expect the FF Rate. The FRB usually adjust the FF rate to influence rates across the curve based on economic conditions given their duel mandate. The FF rate has a lagged impacted on the real economy but its influence on the yield curve provides intelligence as the free market reallocates money based on future expectations. The further out the curve the less influence the FOMC typically has on rates. While QE has greater influence across the curve the Fed has lost market insight from the free mkt. We are now in unchartered water, the task of unwinding said QE policies comes with moral hazards.

La política monetaria puede estabilizar el ciclo económico ajustando las tasas de interés, reservas requeridas y operaciones de mercado abierto. Al reducir las tasas de interés, se estimula el gasto y la inversión durante desaceleraciones económicas, mientras que aumentarlas puede enfriar la economía en momentos de sobrecalentamiento. Además, el banco central puede influir en la oferta de dinero mediante cambios en los requisitos de reservas y operaciones de mercado abierto. Comunicar sus acciones y metas es clave para influir en las expectativas de los inversores y consumidores

Monetary Policy uses interest rate and money supply to smoothen these four phases. Business cycles occur due to demand and excess in the economy and the central bank usually uses its tools like interest rate to help manage these cycles. For example, if the economy is at contraction, it will ease/lower the interest rate and/or increase money supply to limit the contraction by inducing market players to use money to kickstart economic activities and try to make the distance between peak and trough as shallow as possible. This might be overly simplified as there are many nuances to it.

The monetary policy can only be effective in a given economy only when fiscal policy run concurrently with it. There must be synergy by both.

We track the business cycle by keeping track of aggregate demand. Its components are - consumer spending (C), business investment (I), government spending (G), and net exports (X - M) - are pivotal in the business cycle. During economic expansion, C and I surge with consumer confidence and business growth. Government spending and net exports also bolster demand. However, when demand exceeds its peak, it can lead to inflationary pressures called overheating. In a contraction, C falls, I decreases from uncertainty, G may rise to stimulate, and net exports fluctuate. In the trough, C and I hit lows, with G boosting activity. Managing these is vital for navigating cycles effectively. Therefore, policy makers should be certain about the drivers.

The main instruments, targets and channel of transmission of monetary policy depend on each particular country’s monetary and exchange rate regime. The explanation above is correct for “inflation targeting” monetary authorities with a flexible exchange rate regime and an open capital account in the balance of payments. Other countries target money supply (M1, M3 or even M4, depending on the assets considered “money”) as the monetary policy objective, particularly if domestic capital and money markets are not sufficiently deep and effective to properly transmit monetary policy signals through interest rates. A relatively large number of countries have fixed exchange rate regimes, focusing policy in stabilizing the exchange rate.

The role of monetary policy has indeed evolved over time, and its focus has shifted from primarily combating inflation and ensuring price stability to also supporting fiscal policy and stimulating economic growth during economic cycles. However, the extent to which this shift is healthy and effective depends on a complex set of conditions and factors such as Economic condition, Fiscal policy coordination, financial market conditions and maybe political system. The key question which should be asked is the ability of monetary policymakers to strike the right balance between stimulating growth and maintaining macroeconomic stability

Monetary policy uses tools like interest rates, reserve requirements, and open market operations to achieve its goals, like controlling inflation. Policy makers must correctly identify the drivers of high inflation to choose the right tools. If they misjudge, using the wrong instruments or setting inappropriate intermediate targets can lead to unintended consequences, harming economic stability. Accurate analysis is essential to employ effective policies and prevent potential economic disruptions. An example is when there is high inflation due to significant external shocks. Monetary tightening under these circumstances achieves lower inflation, but by eroding living standards, where there is no excess demand generating inflationary heat.

Central banks have 2 main goals: to keep inflation low and to promote full employment. However, there is often a trade-off between these two goals. If a central bank tries to reduce unemployment too much, it may lead to higher inflation. Conversely, if a central bank tries to keep inflation too low, it may lead to higher unemployment. It takes time for monetary policy to have its full effect on the economy. This is because businesses and consumers need time to adjust to changes in interest rates and other monetary policy measures. The lags of monetary policy can also vary depending on the economic conditions. Central banks need to be able to predict how the economy will respond to monetary policy changes in order to make effective decisions

This is known as the "time inconsistency problem," where policymakers must balance short-term challenges that may conflict with long-term goals, such as price stability and full employment. For instance, during recessions, a mix of fiscal and monetary expansion can help in the short term, but it might risk overstimulating the economy in the medium to long term, leading to inflation. To address this issue, many turn to the hierarchical mandate of inflation targeting. Prioritizing this target ensures that other goals fall into place, offering a more effective approach to the time inconsistency problem.

A central bank's success hinges on its credibility. Credibility minimizes uncertainty, bolsters transparency, and steadies expectations. The choice between discretionary and rule-based monetary policy depends. In recent years, many central banks embraced aspects of rule-based policies, like inflation targeting. This approach offers clear guidance, enhancing transparency and accountability. Nevertheless, a one-size-fits-all solution doesn't exist, and central banks often maintain some discretion, even within a rule-based framework. Rule-based policies reduce uncertainty, enhance transparency, and stabilize expectations. They are less vulnerable to political influence and provide a clear road-map for achieving policy goals.

The effectiveness of monetary policy, whether conventional or unconventional, depends on various factors such as independency of monetary policy, financial market integrity, fiscal policy, and the degree of economic openness.

The effectiveness of monetary policy, whether conventional or unconventional, depends on various factors such as financial market integrity, fiscal policy, and the degree of economic openness. Central banks have historically used conventional tools like interest rates, open market operations, and reserve requirements to influence economic variables like inflation, unemployment, and growth. However, in response to events like the COVID-19 pandemic, they've adopted unconventional tools like quantitative easing (QE) to stimulate economies. While QE has been effective, it has also led to an unprecedented increase in the money supply, necessitating careful management to avoid potential issues such as inflation or asset bubbles.

At work, we are observing the entrepreneurial sector exhibiting hesitancy in seeking debt funding due to the Bank of Canada's (BoC) trend of rate hikes. This effect started in mid 2022 and continues today. We are now observing a rising trend of requests to restructured debt obligations as more and more borrowers are having difficulty making scheduled payments. This is a result of elevated interest rates impacting the nominal rate on loans and various other instruments due to the Bank of Canada's rate hikes. Another consideration is that the US treasury yield, and the government of Canada bond yield curves, are inverted. Inverted yield curves are signals of possible recession. This is not always the outcome but it is cause for concern.

Monetary policy has evolved with the adoption of inflation targeting to tackle the time inconsistency problem. Inflation targeting involves central banks publicly committing to a specific inflation rate, fostering transparency and credibility. Against this backdrop, whenever the Central Bank intervenes, during a boom or recession, its operating targets might be more effective. The effectiveness in stabilizing the business cycle lies in the framework's ability to anchor inflation expectations, influence long-term decision-making, and enhance policy credibility. However, its success depends on external factors, policy coordination, and the Central Bank's ability to maintain a balance between inflation control and economic growth.

Monetary Policy (MP) (managing interest rate & inflation) and and Fiscal Policy (FP) (focusing on economic growth) should work in harmony. For Business Cycle, MP has direct & indirect impact. Yes, the transmission time for the MP is 2-3 quarters, but the sentiments does job earlier. In recession, MP will lower interest rates, augment M2/M3 to increase aggregate demand but support should come from FP by higher spending, lower tax & incentives (2008 crises). When the economy is heated with high inflation (post Covid recovery period), only the interest rate hike might not be enough, the tone & spirit of policy will play its part. The unintended impact (like asset bubble, liquidity overhang, unaffordable borrowing) also needs to be watched.

There's an additional question to ponder: Is it really a good idea for the central bank to actively manage the business cycle? As Milton Friedman once noted, "Inflation is always and everywhere a monetary phenomenon." Perhaps maintaining stability is more important than making active interventions against economic ups and downs. It's essential to ask whether the central bank's aim to stabilize short-term economic fluctuations could unintentionally lead to long-term instabilities. Maybe the wiser strategy would be to focus on controlling inflation, ensuring stable and predictable conditions for both businesses and consumers.