How monetary policy is transmitted to the real economy

In the dynamic $31 trillion American economy, policy must evolve as conditions change.

One recent change is that risk markets have become less sensitive to interest rate adjustments as fiscal policy takes center stage amid a profound demographic and technological shift.

For this reason, the mechanism to transmit monetary policy to the real economy has become less effective.

When Congress—the fiscal authority—works in partnership with the Federal Reserve—the monetary authority—the transmission mechanism tends to work well, though with long and variable lags.

But when the two authorities are at odds, the transmission mechanism starts to break down.

For example, when government debt and deficits escalate, the nation’s fiscal condition starts to limit what the central bank can do.

Monetary policy then becomes subordinate to the financing needs of the economy, which distracts the central bank from fulfilling its dual mandate of maintaining price stability and maximum sustainable employment.

In addition, the rising debt burden leads to debt monetization and higher inflation in the medium to long run.

There are periods, like during wartime or a pandemic, when an aggressive fiscal policy is appropriate. But such policies should be discussed in the full light of day so investors and the public can make informed decisions.

Over the past 70 years, both the fiscal authority and the monetary authority have shifted away from wartime interventionist policies like price controls toward greater reliance on market-based decision making.

The responsibility for maintaining price stability and full employment has now fallen to the apolitical Federal Reserve, which has largely achieved that goal.

The Fed, for example, vanquished runaway inflation in 1980 and, more recently, has achieved decades of subdued inflation centered on its 2% target and an unemployment rate consistently under 5%.

Without government involvement, the 12-member Federal Open Market Committee sets the Fed’s overnight policy rate eight times a year. The Fed’s forward guidance sustains expectations of Fed policy, enabling the financial system and the commercial sector to make rational investment decisions.

The Fed’s policy rate decisions no longer seem capricious. By the date of each FOMC meeting, its intentions are already well known, via the notes of the previous meeting and speeches between meetings.

So, what exactly happens when the Fed cuts or increases its policy rate?

First, Wall Street and the banking industry have already dissected the FOMC minutes and speeches and have a good idea of what to expect.

The FOMC has seldom strayed from its formula: research and discussion; forward guidance; and scheduled implementation of its policy.

So when the Fed hikes the federal funds rate, the immediate response comes from the financial markets, where higher interest rates tighten financial conditions.

The increased cost of short-term credit puts a damper on consumer spending while the increased cost of capital moderates business investment, leading to reduced economic activity and downward pressure on inflation.

In the case of a rate hike, concerns over slower economic growth and fewer employment opportunities lead to reduced demand for consumer goods and therefore lower inflation rates.

If the Fed cuts rates, the easing of financial conditions will lead to an increase in investment, consumption and economic activity, with upward pressure on inflation.

Ideally, the transmission of monetary policy is aided by fiscal policy; at worst, transmission is restricted by a counterproductive fiscal policy.

We see the latter example in unfunded tax cuts injecting cash into household balance sheets, which will increase the demand for goods, pushing inflation higher.