One of the unfortunate side effects of central bank independence is that it has allowed, perhaps even encouraged, models of the money transmission mechanism to be deployed which entirely ignore fiscal policy and the resultant interplay between monetary and fiscal measures. In their 2004 paper, Carlin and Soskice wrote that:
“Modern monetary macroeconomics is based on what is increasingly known as the 3-equation New Keynesian model: IS curve, Phillips curve and interest rate-based monetary policy rule (IS-PC-MR). This is the basic analytical structure of Michael Woodford’s book Interest and Prices published in 2003 and, for example, of the widely cited paper “The New Keynesian Science of Monetary Policy” by Clarida et al. published in the Journal of Economic Literature in 1999. An earlier influential paper is Goodfriend and King (1997)….. Moreover, “[t]his is in fact the approach already taken in many of the econometric models used for policy simulations within central banks or international institutions” (Woodford, 2003, p.237).”
Aside from a recent Vox column (Alder et al. 2024), there has not been sufficient awareness of the inherent interactions between public sector debt management and monetary policy. It is our purpose in this column to try to begin to fill that gap.
Central bank behaviour may come under pressure to change as we move into an era focused on debt management, much like the 1970s and 1980s, which stands in contrast to recent decades where debt has not been a binding constraint on monetary policy. Debt will be a permanent feature of the decades to come partly because of the needs of an ageing society, and in part because of the inevitable friction between inflation-sensitive central banks and fiscally expansive administrations prioritising political re-election. Because of this, central banks may in future need to raise policy rates rather quickly and lower them only slowly, a shift away from the way they have conducted monetary policy over recent decades.
A rising debt ratio is likely to increase the sensitivity of monetary policy decisions to their effects on debt management. Note, however, the earlier concern about quantitative easing in Goodhart and Wood (2020). For example, a prospective series of consecutive (small) downwards movements in official interest rates would encourage purchases of (longer-dated) bonds because (i) it would hold out an expectation of immediate capital gains; and (ii) a cycle of small changes in the policy rate mechanically lasts longer, creating a trend that financial markets love. Similarly, the prospect of a series of consecutive upwards movements in official interest rates would deter purchases of government bonds, because of an expectation of potential immediate capital losses.
In the 1970s and 1980s, there were concerns about debt funding because of the desire to hit monetary aggregate targets. The normal approach of monetary policy was to raise interest rates very sharply when necessary, with a view to lowering them afterwards from that immediate peak slowly in order to encourage more debt funding.
In contrast, in recent years, the practice has been rather the reverse. Whenever there has been a potential crisis – as in 2008/9 and then again in 2020 – the practice has been to bring interest rates down sharply. During the relatively rare episodes when inflation has been above target, for a variety of reasons interest rates have been raised somewhat slowly – that is a complete reverse of the practice from the 1970s and 1980s. Persistently low inflation led to abnormally low debt-servicing costs, relieving central banks of the burden of debt management concerns.
We show below in table and charts the distribution of changes in official interest rates both for the UK and the US, for the 15 years from 2008 to 2023 as compared with 1975 to 1990.
Table 1 Changes in Bank Rate
Notes: a) -1.5 in October 2008; b) There was one +0.15 and one -0.15, included under +/- 0.25 to save space; c) -2.0 in November 1980, -2.0 in March 1981; d) Between October 1981 and June 1984, and again in January 1985, the changes in the official rate were not exactly in steps of a multiple of 25 basis points. We have rounded them to the nearest 25 basis point multiple for greater simplicity/clarity; e) +3.0 in November 1979.
Table 2 Changes in Fed Funds rate
Figure 1a Bank of England 2008-2023: Rate changes by size (% total episodes)
Figure 1b Bank of England 1975-1990: Rate changes by size (% total episodes)
Figure 2a Federal Reserve: 2008-2023: Rate changes by size (% total episodes)
Figure 2b Federal Reserve 1975-1990: Rate changes by size (% total episodes)
The difference in approaches to policy across both periods is rather stark. In the later period, there were no upwards changes in interest rates greater than 75 basis points in either country. In the earlier period, in the UK there were considerably more increases in interest rates greater than 1% (21 in all) compared to only seven small increases of 75 basis points or less. In the US, most of the upwards movements in the earlier period in interest rates were delivered in large jumps. When interest rates were being cut down in the recent period in the UK there were two cuts in rates of 1% or greater, compared to eight cuts less than 50 basis points, whereas in the earlier period there were five cuts in interest rates of 1% or more, compared with nearly 75 cuts of 50 basis points or less.
Overall, the recent period was comparatively stable, with rates in the UK starting at 5.5 in January 2008 and ending at 5.25 on December 2023. All that happened was a decline from this level, in and after the global financial crisis, down to 0.10 and then a resultant rise starting from December 2021 back to 5.25 in December 2023. In contrast, in the earlier period, the official interest rates started at 11.25 in January 1975 and ended at 13.88 in December 1990. But in between there were increases in rates of about 3,300 basis points, as compared with a decrease of about 3,050. In other words, the volatility of interest rates was about six times greater in the earlier period. Many – perhaps most – current observers have regarded the increase in interest rates from December 2021 to December 2023, of some 5% in all, as being rather abrupt. This averaged from trough to peak an increase of about 20 basis points a month. Compared to the earlier period, this was comparatively lackadaisical. From March 1976 until October 1976, the bank rate rose from 9% to 15%, an average of about 75 basis points per month. Again, between January 1978 and February 1979, interest rates increased from 6.5 to 14.0, an average of about 65 basis points per month. Between April 1979 and November 1979, interest rates rose by 5%, an average of 40 basis points per month. There was a similar equally sharp increase in 1973, outside our data period.
If fiscal considerations mean that debt management concerns become a constraint on monetary policy, then the speed and scale of interest rate increases may need to become very much greater and faster than was experienced in the run up from 2021 to a (temporary) peak at the end of 2023. The experience of the volatile periods in the 1970s and 1980s suggests that financial markets should prepare for periods of much more rapid interest rate increases, with implications for the broader financial sector. Stress tests of banks relating to interest rate risk, for example, may need to be made much more extreme than might be expected from the years of the Great Moderation.
References
Alder, M, N Coimbra, and U Szczerbowicz (2024), “Firms’ debt structure matters for monetary policy transmission”, VoxEU.org, 11 May.
Carlin, W, and D Soskice (2004), “The 3-Equation New Keynesian Model: A Graphical Exposition”, CEPR Discussion Paper 4588.
Clarida, R, J Gali and M Gertler (1999), “The Science of Monetary Policy: A New Keynesian Perspective”, Journal of Economic Literature 37(4): 1661-1707.
Goodfriend, M and R King (1997), “The New Neoclassical Synthesis and the Role of Monetary Policy”, NBER Macroeconomics Annual, pp. 231-283.
Wood, G, and C Goodhart (2020), “The internal contradictions of macro-monetary policy”, VoxEU.org, 24 January.
Woodford, M (2003), Interest and Prices: Foundations of a Theory of Monetary Policy, Princeton University Press.
