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What is Contractionary Monetary Policy?
Tightening monetary policy is the process by which the central bank uses various tools to reduce inflation and the overall level of economic activity. Central banks do this by raising interest rates, raising the reserve requirement ratio for commercial banks, and reducing the money supply (also known as quantitative tightening (QT)) through massive sales of government bonds.
It may seem counterintuitive to want to reduce the level of economic activity, but running the economy faster than sustainable levels can have undesirable effects, such as inflation – a general increase in the prices of typical goods and services that households buy.
As a result, central bankers use a range of monetary tools to deliberately reduce the level of economic activity without throwing the economy into chaos. This delicate balancing act is often referred to as a “soft landing,” as officials deliberately alter their finances, forcing individuals and businesses to think more carefully about current and future purchases.
Tight monetary policy usually follows a period of supportive or “easy monetary policy” (see quantitative easing), in which the central bank eases economic conditions by lowering national interest rates to reduce borrowing costs; and increases the economy by selling large amounts of bonds in the money supply. When interest rates are near zero, borrowing costs are practically free, spurring post-recession investment and general spending.
Contractionary Monetary Policy Tools
The central bank is taking advantage of the opportunity to raise benchmark interest rates, increase the reserve requirement ratio for commercial banks and sell bonds in bulk. Each is checked below:
1) Raising the Benchmark Interest Rate
The reference rate or benchmark rate refers to the overnight lending rate charged by the central bank to commercial banks. It acts as an interest rate from which other interest rates are derived. For example, a mortgage or personal loan includes a reference rate plus an additional percentage that commercial banks use to lend to generate interest income and any associated risk premium to compensate the institution for the unique credit risk to each individual.
Therefore, an increase in the base rate will lead to an increase in all other interest rates related to the base rate, resulting in an increase in interest-related costs in general. Higher costs mean less disposable income for individuals and businesses, leading to less spending and less money running around the economy.
2)
Increased reserve requirements
Commercial banks must hold a small percentage of customer deposits at the central bank to pay off debts in the event of sudden withdrawals. It is also a means by which the central bank controls the money supply in the economy. If the central bank wants to control the amount of money flowing through the financial system, it can raise reserve requirements, thereby preventing commercial banks from lending those funds to the public.
3) Open market operations (bond batch sales)
Central banks have also tightened funding conditions by selling large quantities of government securities (often loosely referred to as “government bonds”). In studying this section, we will consider U.S. Treasuries for simplicity, but the principles remain the same for any other central bank. Selling the bond means the buyer/investor has to come up with their money , the central bank effectively removes the bond from the system long-term during its lifetime.
The Effect of Contractionary Monetary Policy
Contractionary monetary policy has the effect of lowering economic activity and lowering inflation.
1)
Impact of high interest rates: High interest rates in the economy make borrowing more expensive, which means that large-scale capital investment, as well as general spending, tends to slow. At the individual level, mortgage payments are increasing, leading to a reduction in household disposable income.
Another contractionary effect of higher interest rates is a higher opportunity cost of spending. In an environment of rising interest rates, interest-linked investments and bank deposits become more attractive because savers can make more money with their money. However, inflation still needs to be considered, because if high inflation is higher than nominal interest rates, high inflation will still generate negative real returns for savers.
2)
Impact of increasing reserve requirements: While reserve requirements are designed to provide a liquidity pool for commercial banks during times of stress, they can also be modified to control the money supply to the economy. When the economy is overheating, the central bank can raise the reserve requirement ratio, forcing banks to hold more capital than before, which directly reduces the amount banks can lend. Higher interest rates combined with less credit issuance would reduce economic activity as expected.
3) Impact of open market operations (bulk selling of bonds): U.S. Treasuries have different maturities and interest rates (“T-Bills” have maturities of 4 weeks to 1 year, “Notes” have maturities of 2 to 10 years, and “Bonds” 20 to 30 years). Treasuries are considered to be as close to a “risk-free” investment as possible and are therefore often used as a benchmark for loans with appropriate time horizons, ie. H. interest rate at
The massive sale of bonds lowered their prices, effectively raising their yields. Higher-yielding government bonds (bonds) mean it is more expensive for the government to borrow money, so unnecessary spending must be curbed.
Examples of Contractionary Monetary Policy
Tightening monetary policy is more straightforward in theory than in practice because there are many exogenous variables that can affect the outcome. Because of this, central bankers strive to remain nimble by giving themselves options to deal with unexpected outcomes, and tend to take a “data-dependent” approach when dealing with different situations.
The examples below include the US interest rate (Federal Funds rate), real GDP, and inflation (CPI) using tightening policy twice in 20 years. The point is that inflation tends to lag the rate hike process because it takes time for rate hikes to filter through the economy to have the desired effect. Thus, as interest rates rose, inflation continued to trend upward from May 2004 to June 2006, before eventually falling. The same is true for the period from December 2015 to December 2018.
Chart: Example of Contractionary Monetary Policy Examined
Source: Refinitiv Datastream
In both cases, restrictive monetary policy could not fully work because two different crises destabilized the entire financial landscape. In 2008/2009, we experienced the Global Financial Crisis (GFC), and in 2020, the spread of the coronavirus shook markets, bringing global trade to a standstill almost overnight.
These examples underscore the daunting task of deploying and implementing contractionary monetary policy. Granted, the pandemic is a global health crisis, and the global financial crisis started with greed, financial misconduct and regulatory failure. The most important thing to note in both cases is that monetary policy does not exist in a bubble and is vulnerable to shocks within or outside the financial system. This can be compared to a pilot flying under controlled conditions in a flight simulator, to a real flight where the pilot can be asked to land the plane in a strong 90-degree crosswind.
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