What is contractionary monetary policy?
shrink monetary policy It is the process by which the central bank uses various tools to reduce inflation and the general level of economic activity. Central banks do this through a combination of raising interest rates, raising reserve requirements for commercial banks and reducing the money supply through large-scale sales of government bonds, also known as quantitative tightening (QT).
It may seem counterintuitive to want to reduce the level of economic activity, but an economy that operates above a sustainable rate produces undesirable effects such as inflation The general rise in the prices of typical goods and services purchased by households.
Therefore, central bankers use a number of monetary tools to deliberately lower the level of economic activity without driving the economy into a meltdown. This delicate equilibrium is often referred to as a “soft landing” as officials intentionally alter financial conditions, forcing individuals and businesses to think more carefully about current and future buying behaviors.
Contractionary monetary policy is often followed by a period of supportive or “accommodative” monetary policy (see quantitative easing) where central banks facilitate economic conditions by lowering the cost of borrowing by lowering the country’s benchmark interest rate; And by increasing the money supply in the economy through wholesale bond sales. When interest rates are close to zero, the cost of borrowing money is almost free which stimulates investment and public spending in the economy after recession.
contractionary monetary policy tools
Central banks benefit from raising the benchmark interest rate, raising reserve requirements for commercial banks, and wholesale bond sales. Each is explored below:
1) raise the benchmark interest rate
The standard interest rate or base rate refers to the interest rate charged by the central bank to commercial banks in exchange for overnight loans. It acts as the interest rate from which other interest rates are derived. For example, a mortgage or personal loan will consist of the standard interest rate plus an additional percentage that the commercial bank applies to the loan to provide interest income and any related risk premium to offset the institution for any credit risk unique to the individual.
Therefore, raising the prime rate raises all other interest rates associated with the prime rate, resulting in higher interest-related costs across the board. Higher costs make individuals and companies less disposable income which results in less spending and less money circulating around the economy.
2) Increased reserve requirement
Commercial banks have to keep a small portion of customers’ deposits with the central bank in order to meet the obligations in the event of a sudden drawdown. It is also a means by which the central bank controls the money supply in the economy. When the central bank wants to control the amount of money flowing through the financial system, it can raise the reserve requirement that prevents commercial banks from lending that money to the public.
3) Open Market Operations (Massive Bond Sales)
Central banks also tighten financial conditions by selling large amounts of government securities, often referred to as “government bonds.” In exploring this section, we will consider US government securities for easy reference but the principles remain the same for any other central bank. Selling bonds means that the buyer/investor has to part with their money, which the central bank effectively removes from the system for an extended period of time during the life of the bond.
The effect of contractionary monetary policy
Contractionary monetary policy has the effect of reducing economic activity and lowering inflation.
1) The effect of higher interest ratesHigher interest rates in the economy make it more expensive to borrow money, which means that large-scale capital investment tends to slow along with public spending. At the individual level, mortgage payments are rising, leaving families with lower disposable incomes.
Another deflationary effect of higher interest rates is the higher opportunity cost of spending money. Interest-linked investments and bank deposits become more attractive in a high interest rate environment where savers are expected to earn more of their money. However, inflation still needs to be taken into account as high inflation will still leave savers with a negative real return if it is higher than the nominal interest rate.
2) The effect of increasing reserve requirements: While reserve requirements are used to provide a range of liquidity to commercial banks in times of trouble, they can also be changed to control the money supply in the economy. When the economy is overheating, central banks can increase reserve requirements, forcing banks to withhold a larger portion of capital than before, which directly reduces the amount of loans banks can make. Higher interest rates with fewer loans being issued, reduce economic activity, as intended.
3) Impact of open market operations (collective bond sales): US Department of the Treasury Securities have different life spans and interest rates (“Treasury Bills” maturing anywhere between 4 weeks to 1 year, “bank notes” anywhere between 2 to 10 years and “bonds” from 20 to 30 years). treasury bonds It is as close as possible to a “risk free” investment, therefore Often used as a benchmark for loans with corresponding time horizons, that is, the interest rate on a 30-year Treasury bond can be used as a benchmark when issuing a 30-year mortgage at an interest rate above the benchmark.
Selling large amounts of bonds effectively lowers the bond’s price and raises the bond’s yield. The higher yield on Treasuries (bonds) means that it is more expensive for the government to borrow money and, therefore, it will have to control any unnecessary spending.
Examples of contractionary monetary policy
contractionary monetary policy Clearer In theory than in practice There are a lot of external variables that can influence the outcome of this. This is why central bankers try to be smart, providing themselves with options to navigate unintended outcomes and tend to adopt a “data-driven” approach when responding to different situations.
The example below includes the US interest rate (the federal funds rate), real GDP, and inflation (CPI) over a 20-year period where deflation was applied twice. The important thing to note is that inflation tends to delay the process of raising prices because raising prices takes time to filter through the economy to achieve the desired effect. As such, inflation from May 2004 to June 2006 continued its upward trend as prices rose, before finally declining. The same was observed during the period from December 2015 to December 2018.
Schedule: Examine an example of contractionary monetary policy
Source: Refinitiv Datastream
In both examples, contractionary monetary policy could not run its full course as two different crises destabilized the entire financial landscape. In 2008/2009 we witnessed the Global Financial Crisis (GFC) and in 2020 the spread of the Coronavirus shook markets leading to a closure that brought global trade to a halt almost overnight.
These examples underscore the difficult task of using and implementing contractionary monetary policy. Admittedly, the pandemic was a global health crisis and the global financial crisis emerged from greed, financial error and regulatory failure. The most important thing to note from either case is that monetary policy does not exist in a bubble and is vulnerable to any internal or external shocks to the financial system. It can be likened to a pilot flying under controlled conditions in a flight simulator compared to a real flight where a pilot can be called to land an aircraft during strong 90 degree cross winds.