WHAT IS CONTRACTIONARY MONEY POLICY?
Contractionary monetary policy is a strategic approach employed by central banks to combat inflation and control the overall economic activity. This involves using tools such as raising interest rates, increasing reserve requirements for commercial banks, and conducting large-scale government bond sales, also known as quantitative tightening (QT).
Although it may seem counter-intuitive to lower economic activity, an economy operating above its sustainable rate can lead to unwanted consequences like inflation, which causes a general rise in the prices of goods and services purchased by households.
Therefore, central bankers utilize various monetary tools to intentionally reduce economic activity without causing a severe downturn. This delicate balancing act is often referred to as a 'soft landing,' as officials deliberately adjust financial conditions to prompt individuals and businesses to carefully consider their current and future purchasing decisions.
Contractionary monetary policy typically follows a period of supportive or 'accommodative monetary policy' (as seen in quantitative easing). During this phase, central banks ease economic conditions by lowering the cost of borrowing through a reduction in the country's benchmark interest rate and increasing the supply of money in the economy through mass bond sales. When interest rates are close to zero, the cost of borrowing becomes extremely low, stimulating investment and overall spending in an economy recovering from a recession.
CONTRACTIONARY MONEY POLICY TOOLS
Central banks employ various tools to control the economy, such as increasing the benchmark interest rate, raising reserve requirements for commercial banks, and conducting open market operations involving mass bond sales.
1) Escalating the Benchmark Interest Rate:
The central bank sets the benchmark interest rate, which is the rate charged to commercial banks for overnight loans. This rate serves as the basis for other interest rates in the economy. When the central bank raises the benchmark interest rate, it causes all other interest rates linked to it to increase as well. This results in higher interest-related costs for individuals and businesses, leading to reduced disposable income, less spending, and a decrease in money circulation in the economy.
2) Augmenting Reserve Requirements:
Commercial banks are obliged to keep a certain portion of their clients' deposits with the central bank to meet potential liabilities in case of sudden withdrawals. By adjusting the reserve requirement, the central bank can influence the money supply in the economy. When the central bank aims to decrease the money flow in the financial system, it can raise the reserve requirement, restricting commercial banks from lending out a significant portion of the money to the public.
3) Open Market Operations (Large-Scale Bond Sales):
Central banks can tighten financial conditions by selling substantial amounts of government securities, commonly known as government bonds. Although we'll focus on US government securities for simplicity, this principle applies to any other central bank as well. When the central bank sells bonds, it essentially takes money from investors who purchase the bonds and removes it from the system for the duration of the bond's lifetime. This reduction in available funds can further limit money supply and economic activity.
THE EFFECT OF CONTRACTIONARY MONETARY POLICY
Contractionary monetary policy has the impact of reducing economic activity and decreasing inflation.
1) Consequence of Elevated Interest Rates: Increased interest rates in an economy result in higher borrowing costs, leading to a slowdown in significant capital investments and overall spending. At an individual level, mortgage payments rise, leaving households with less disposable income.
Another effect of higher interest rates is the elevated opportunity cost of spending money. As interest-linked investments and bank deposits become more appealing in a rising interest rate environment, savers stand to earn more on their money. However, inflation still needs to be considered, as high inflation can leave savers with a negative real return if it exceeds the nominal interest rate.
2) Consequence of Raising Reserve Requirements: Reserve requirements serve to provide a pool of liquidity for commercial banks during times of stress but can also be adjusted to control the money supply in the economy. When the economy is overheating, central banks can increase reserve requirements, compelling banks to hold a larger portion of capital, thereby reducing the amount of loans banks can issue. The combination of higher interest rates and fewer loans being issued leads to reduced economic activity, as intended.
3) Consequence of Open Market Operations (Large-scale Bond Sales): US treasury securities have varying lifespans and interest rates, with T-bills maturing between 4 weeks to 1 year, notes between 2 to 10 years, and bonds between 20 to 30 years. Treasuries are considered nearly "risk-free" investments and often serve as benchmarks for loans with corresponding time horizons. For instance, the interest rate on a 30-year treasury bond can be used as a benchmark when issuing a 30-year mortgage with an interest rate above the benchmark to account for risk.
Selling large quantities of bonds lowers the bond price and effectively raises the bond yield. A higher yielding treasury security (bond) implies higher borrowing costs for the government, leading to the necessity of reining in unnecessary spending.
EXAMPLES OF CONYTRACTIONARY MONETARY POLICY
Contractionary monetary policy is more straightforward in theory than it is in practice as there are numerous external factors that can influence its outcome. That is why central bankers strive to be adaptable, equipping themselves with options to navigate unintended consequences and adopting a data-dependent approach when responding to various situations.
The following example encompasses the US interest rate (Federal funds rate), real GDP, and inflation (CPI) over a 20-year period during which contractionary policy was implemented twice. It is essential to note that inflation tends to lag behind the rate-hiking process because these rate hikes take time to propagate through the economy and have the desired effect. Consequently, inflation continued to rise from May 2004 to June 2006, even as rates increased, before eventually declining. The same pattern was observed during the period from December 2015 to December 2018.
Graph: Illustration of Constrictive Monetary Measures Analyzed
In both of these instances, the implementation of contractionary monetary policy faced significant challenges due to unforeseen crises that destabilized the entire financial landscape. The 2008/2009 global financial crisis (GFC) and the 2020 coronavirus pandemic led to abrupt market disruptions and widespread lockdowns, severely impacting global trade.
These examples highlight the arduous nature of adopting and executing contractionary monetary policy. Admittedly, the pandemic represented a global health emergency, while the GFC arose from a combination of greed, financial misconduct, and regulatory failures. The crucial takeaway from both cases is that monetary policy cannot operate in isolation; it remains susceptible to internal and external shocks within the financial system. It can be likened to a pilot navigating controlled conditions in a flight simulator versus handling a real flight amidst challenging 90-degree crosswinds.
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