In this blog post, we examine how adjustments to the benchmark interest rate—a key tool of monetary policy—affect the economy, as well as the importance of timing and methodology.
The Role and Importance of Monetary Policy
Monetary policy refers to the central bank’s adjustment of interest rates or the money supply to achieve economic objectives such as price stability. It has a significant impact across the entire economy and plays an essential role in promoting the stability and growth of the national economy. “Open market operations,” a representative monetary policy tool, involve the central bank buying and selling bonds with private financial institutions to bring interest rates in the financial market in line with the policy-set benchmark interest rate. When the central bank buys bonds, interest rates fall; when it sells bonds, interest rates rise. Lower interest rates stimulate consumption and investment, boosting economic activity and increasing inflation, while higher interest rates cause the economy to contract and inflation to decline. In this way, the effects of open market operations ripple throughout the entire economy.
Monetary policy does not stop at simply adjusting interest rates; it must also consider a broader range of economic impacts. For example, monetary policy also affects the unemployment rate. When interest rates fall, the cost of investment for businesses decreases, allowing them to create more jobs, which can ultimately lead to a decline in the unemployment rate. Conversely, when interest rates rise, the cost of investment for businesses increases, and employment may decline. Therefore, the central bank can use monetary policy to promote not only price stability but also employment stability.
The Importance of Proactiveness and Policy Credibility
Among the requirements for a central bank’s monetary policy to achieve its intended effects are “proactiveness” and “policy credibility.” First, for monetary policy to be proactive, the central bank must anticipate economic fluctuations and take preemptive action. There is a time lag between the decision to set the policy rate and the conduct of open market operations and the actual manifestation of their effects; this is referred to as the “exogenous policy lag,” and it is precisely this lag that makes proactiveness a critical issue. For example, if a central bank waits until the economy has already entered a recession before lowering the benchmark interest rate, the policy lag may cause the policy effects to materialize only after the economy has already emerged from the recession on its own. In such a case, side effects such as economic overheating may occur. Therefore, it is desirable for the central bank to conduct monetary policy proactively.
Furthermore, monetary policy cannot succeed without public confidence. Consequently, the central bank must take care not to undermine the credibility of its policies. However, there are differing views on how monetary policy can earn the public’s trust. Economist Milton Friedman advocates “rule-based policy,” in which the central bank commits to specific policy objectives or operational methods as “rules” and adheres to them under all circumstances. For instance, suppose the central bank promises the public a target inflation rate. If the public trusts this promise, inflationary fears will subside. However, once prices have stabilized, the central bank may then consider stimulating the economy. The problem is that if the public perceives this inconsistency, trust in the central bank will be undermined. Rule-based advocates argue that in such cases, it is preferable for the central bank to consistently adhere to its original promise.
Central bank independence is also crucial for enhancing the credibility of monetary policy. If the central bank can operate independently of the government and political pressures, this can help boost public confidence. An independent central bank can implement policies aimed at long-term economic stability, which increases economic predictability and enhances public trust.
The Conflict Between Rule-Based and Discretionary Approaches
However, it is also true that the public finds it difficult to judge whether the central bank intended to adhere to the rules based solely on ex post results, and that there is no way to compel the central bank to follow the rules. In contrast to rule-based approaches, “discretionary” approaches support flexible policy responses to changing economic conditions and view the strict implementation of rule-based approaches as practically difficult.
Furthermore, it raises the question of whether rule-based policy is truly the best approach. This is because, in the event of economic fluctuations larger than anticipated, pre-established rules can become an obstacle. While policy credibility is important, this does not mean that the central bank must be bound by rules at all costs.
Discretionary advocates believe it is more desirable for the central bank to respond flexibly depending on the situation. For example, if an unexpected global financial crisis occurs, the central bank may fail to respond appropriately if it adheres strictly to pre-set rules. Conversely, adjusting policy at its discretion allows for a more effective response to crisis situations. Therefore, the central bank needs to operate monetary policy by appropriately combining rules and discretion depending on the situation.
Finally, the transparency of central bank policies is a crucial factor in building public trust. The central bank must transparently disclose its policy-making process and clearly explain the background and rationale behind policy changes. This enables the public to understand and trust the central bank’s policies. Policy transparency facilitates smooth communication between the central bank and the public, which ultimately contributes to enhancing economic stability.
