Balancing Act: How Stock Markets React to Higher Interest Rates
Interest Rates: How the Transmission Channels are Failing the Real Economy
The Bank of England’s base rate has been raised steadily over the past year, but the impacts of these rate hikes are not being felt in the real economy. Despite this, economies remain resilient, leading many to speculate that the transmission channels through which monetary policy usually works are not functioning as expected, bringing into question the key tool of monetary policy.
Transmission Lag in Interest Rates
While the BoE’s base rate, the main tool of monetary policy, directly affects a narrow set of financial institutions, its impacts are believed to accumulate over time. The assumption is that it takes 18-24 months for the impacts of monetary policy to feed through to the inflation rate. However, this period might have been altered due to changes in recent years. For example, over the past decade, private debt has generally lengthened in maturity, and variable rates have become less prevalent, shielding households from higher rates. This means that the impact of tighter monetary policy will take more time to be fully transmitted.
Asset Price Behavior
Higher interest rates should naturally impact discount factors and signal a worsening economic outlook to financial markets. But recently, it’s been observed that asset prices have not behaved as expected – this could be due to equity performance offsetting some of the tightening efforts of the BoE’s monetary policy committee. Additionally, markets are already factoring in a policy pivot, which has led to financial conditions loosening. This has led MPC members to believe that monetary policy will have to be tighter for longer to ensure inflation returns sustainably back to the 2% target rate.
Debt Structure and Its Impact on Transmission
The BIS has recently noted that lengthening debt maturity could mean that economic demand is more sensitive to interest rate hikes due to the high private debt levels. However, the prevalence of fixed-rate deals has increased over the last decade, shielding households from higher rates. This means that the impact of tighter monetary policy will take more time to be fully transmitted to the real economy than in the past. This may explain why the economy remains resilient despite the tightening monetary policy.
- The effective rate on mortgages rose to just 2.4% in Q4 of 2018, despite the assumed jump to 3% by the end of 2022 by the OBR.
- There is no consensus on why the transmission channels seem to be failing recently.
While the BoE’s base rate remains an important tool of monetary policy, the transmission channels seem to fail to bring about real economic change as fast as they used to. This is due to factors such as changes in debt structure, changes in the equity market, and pre-existing market expectations. These shifts require policy changes that might affect how markets function.
Despite the changes in debt structures and the lengthening of debt maturities, the BoE has to continue using the base rate as the main tool of monetary policy. However, changes are required to make the transmission channels more effective. In the meantime, the BoE has to rely on alternative forms of policy, such as forward guidance, to help steer the economy in the desired direction. Whether or not the transmission channels can be restored to their former efficacy remains to be seen.