The monetary transmission mechanism is the process by which decisions taken by a central bank work their way through financial markets and the banking system to affect the wider economy, and in the end the rate of inflation. A central bank directly controls only a very short-term interest rate and the terms on which it deals with banks. Everything else, including mortgage rates, company borrowing costs, share prices, the exchange rate and household spending, responds indirectly. The transmission mechanism is the name for those indirect links.
Understanding it is central to monetary policy, because policymakers must judge how large a rate change is needed and how long it will take to act. The mechanism is not a single pipe but several channels operating at once, with strengths that differ between countries and change over time. Central banks devote much of their research and forecasting effort to estimating it.
From the policy rate to market rates
Transmission begins with the policy interest rate. When the central bank changes it, overnight rates in the money markets follow almost at once, because banks can borrow from or deposit with the central bank at rates tied to the policy rate. Longer-term rates depend on what markets expect the policy rate to be in future, so they respond both to the decision and to what the central bank says about its intentions. Bond yields, swap rates and the rates banks charge on new loans and pay on deposits then adjust, though bank rates often move more slowly and less than one for one.
Main channels
Economists usually distinguish the following routes from financial conditions to spending:
- Interest rate channel. Higher borrowing costs discourage investment by firms and purchases of housing and durable goods by households, and they raise the reward for saving. This is the traditional channel in textbook models.
- Credit channel. Tighter policy reduces banks' willingness and ability to lend and weakens borrowers' balance sheets by lowering the value of their collateral, so credit becomes scarcer as well as dearer. Small firms and households that depend on banks are most affected.
- Asset price channel. Higher rates lower the prices of shares, bonds and property. Households feel less wealthy and spend less, and firms find it more costly to raise equity.
- Exchange rate channel. Higher rates tend to attract capital and strengthen the currency. Imports become cheaper, which lowers inflation directly, and exports become less competitive, which reduces demand. The link is described by the behaviour of the exchange rate and is strongest in small open economies.
- Expectations channel. If households and firms believe the central bank will keep inflation near its target, they set wages and prices accordingly, and less change in actual rates is required. Credibility under inflation targeting is meant to strengthen this channel.
A cash-flow effect operates alongside these: where many loans carry variable rates, a rate rise quickly increases the payments of existing borrowers and reduces what they have left to spend, while raising the income of savers.
Time lags and uncertainty
The effects are neither immediate nor precisely predictable. Financial prices react within minutes, but spending decisions take months to change, and prices and wages longer still. Central banks commonly estimate that the peak effect of a rate change on output comes after about a year and on inflation after one to two years, and the economist Milton Friedman's description of the lags as long and variable remains widely quoted. Policy must therefore be set on the basis of forecasts rather than current data, which is why central banks publish projections and why mistakes are costly to correct.
The structure of the financial system shapes the speed of transmission. Economies in which mortgages are mostly at variable rates respond faster than those dominated by long fixed-rate loans. A larger role for bond markets relative to banks, the level of household and corporate debt, and the degree of competition among banks all matter. During a business cycle downturn the same rate cut may have less effect if borrowers are unwilling to take on debt.
When transmission is impaired
Transmission can break down. In a financial crisis, banks short of capital or funding may not pass on lower rates, and market rates may diverge sharply between borrowers or, in a currency union, between member countries. When the policy rate approaches the zero lower bound, the central bank cannot cut much further, and in a liquidity trap additional money has little effect on spending.
Central banks responded to these conditions after 2008 with other instruments intended to act on parts of the chain directly. Quantitative easing lowers long-term yields by purchasing bonds, forward guidance works through expectations of future rates, and targeted lending schemes support bank credit. Some central banks adopted negative interest rates.
In emerging and dollarised economies
Transmission is generally weaker where financial markets are shallow, a large share of the population has no bank account, or loans and deposits are denominated in a foreign currency. In such economies the exchange rate channel tends to dominate, the central bank may rely more on reserve requirements and direct controls, and the scope for independent policy is narrower. The operations by which the central bank steers market rates in the first place are described under open market operations.