Ideas: Do we trust monetary policy too much?

This article first appeared in Forum, The Edge Malaysia Weekly, on February 3, 2020 - February 09, 2020.
Ideas: Do we trust monetary policy too much?
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Bank Negara Malaysia recently reduced the overnight policy rate by 25 basis points to 2.75%, the lowest level since 2011. With this measure, the central bank hopes to improve the growth trajectory.

While a growing number of economists are sceptical about recognising the eventual stimulus role played by cuts in the interest rate, and some of them believe that such a measure is key in generating boom and bust cycles, the first question I wish to pose is: Are we trusting monetary policy too much?

Indeed, if it would work perfectly as described by textbooks — lower the rate to stimulate the economy and raise it to cool down prices — monetary policy would be an easy tool, and we would not experience economic crises. In fact, central bank actions are based on past information (and information always evolves), and it takes time for such actions to produce effects (and the bigger the time lag, the bigger the evolution of the context).

It is important to understand that monetary policy is a signal more than an objective fact. By lowering the interest rate, the central bank wishes to communicate that more financial resources have been made available for investment (or that borrowing money is cheaper).

However, as economists such as Friedrich Hayek, Ludwig Lachmann and Don Lavoie have taught us, economic reality is not shaped merely by facts; what counts more is the way in which economic agents interpret the signals generated by objective facts. Prices, for example, are objective figures, but purchasing decisions are taken by consumers according to how those figures are interpreted by them.

The objective fact here is the interest rate cut. One potential interpretation is that more financial resources are available — or that “money is cheaper” — and this would eventually call for more investment (which may be also malinvestment).

However, this is not the only possible interpretation. Market players may think that the central bank is worried about the present status of the economy and therefore may become even more conservative and hold back. In a nutshell, the economy is made by billions of individual actions linked by signal interpretations; in such a system, nothing is automatic and the result of an action is open-ended by nature.

The second point I wish to raise is strictly linked to the first one. The underlying question is still the same: Do we trust monetary policy too much? When we believe that the interest rate is the main driver for investment, we are disregarding the basic fact that entrepreneurial decisions are mainly driven by profit expectations. It is enough to look at the mixed results produced by quantitative easing in Europe: If businesspeople do not expect a bright future, no matter how low the interest rate is, they simply do not invest.

In the context of Malaysia, for example, a clearer political framework could play a bigger role in stimulating economic activity than expansionary monetary policies. It would be important for the government to have a clearer political economy agenda, in order for investors to have a better idea of what to expect for the future, to know in which context their entrepreneurial and investment activities would unfold. In fact, if profit expectations are the main driver for investment, a general climate of uncertainty would make it more difficult to form that positive profit expectation, negatively affecting the business mood.

A clearer political scenario may thus produce better effects than monetary policy. In fact, while cutting the interest rate directly affects the quantity of money, stimulating the economy by virtually “creating” resources and risking overinflating the economic system, a higher degree of certainty at the institutional level is “neutral” — it does not affect economic variables, but simply creates a better and safer environment for entrepreneurial actions.

Carmelo Ferlito is senior fellow at the Institute for Democracy and Economic Affairs (IDEAS)

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