Illustration:: Katmandu Journal
A central banker yanks up interest rates. The economy, after a time, slows. Inflation then cools. This is how it has worked for decades, the mechanics as reliable as an old pocket watch. Yet today the watch is losing time. The same monetary-policy adjustments are producing weaker and more delayed effects. The world’s most important economic tool is becoming a blunter instrument.
In 2022 and 2023, central banks in the rich world hiked interest rates at the fastest pace in four decades. (They have since started lowering them.) The goal was to curb soaring consumer prices. Yet inflation, though substantially down from their peaks, remains above the official target of 2 percent in major economies, and economic growth has proved surprisingly resilient in spite of painful borrowing costs. Asset prices, especially in America, have boomed, too.
In fact, buoyant equity markets can actively counteract central-bank policy. In America, soaring technology stocks, fuelled by optimism about artificial intelligence, have eased financial conditions even as the Federal Reserve has kept interest rates high. That is because rising wealth encourages more spending and investment, creating a channel that works against tighter monetary policy. The central banker’s foot is on the brake, but the market is pressing a separate accelerator.
Interest rates operate through indirect channels. By making borrowing more dearer, they cool demand for everything from new factories and houses to household appliances and vehicles. A stronger currency, a side-effect of higher rates, also helps to strangle inflation by making imports cheaper. But these mechanisms depend on sensitivity to the cost of credit. That sensitivity is waning.
One principal reason is the structure of debt itself. In many rich economies (also in Nepal), a big share of mortgages and corporate loans are fixed for long periods. Homeowners in parts of Europe, for example, have locked in low rates for decades. Their monthly payments remain unchanged even as central banks push up rates. The full impact will not be felt until these loans are refinanced, a process that could stretch to 2030. The immediate sting of monetary policy is thereby dulled.
The very composition of modern economies also dampens the response. Manufacturing and construction, which are highly sensitive to borrowing costs, have shrunk as a share of GDP. In fact, their place has been taken by services—healthcare, hospitality, professional support—which are less reliant on credit for their expansion. A family might take out a loan to buy a car; it will not borrow to pay for a haircut or a restaurant meal. Employment in these service sectors has therefore remained stubbornly resilient even as central banks tried to cool the labour market.
Meanwhile, a more profound shift is under way in the nature of investment. Companies are increasingly spending on intangible assets—software, research, brand development—rather than physical machinery and buildings. Such investments are typically financed from corporate cash flows or equity issuance, instead of bank loans. Consider the current boom in artificial intelligence. The vast data centres required are largely being paid for by the immense operating profits of the technology giants, not by debt raised at high interest rates. This decoupling from the credit markets then means that monetary tightening fails to bite where much of today’s growth is being generated.
All these sorts of changes have sobering implications. To achieve the same economic slowdown as in the past, central banks may need to push rates higher or hold them there for longer. The effects are also more uneven. Those with variable-rate debt or in need of new credit bear the full brunt, whereas big corporations and fixed-rate borrowers are insulated. This unevenness makes it dangerously easy to over-tighten, crushing the sensitive parts of the economy while leaving others untouched. Furthermore, monetary policy is primarily a tool for managing demand. It is ill-suited to combat the supply-side shocks—like disrupted energy markets or fragmenting trade links—that have become more frequent.
That said, none of all this renders central banks obsolete. Their power to anchor inflation expectations remains vital. Only the burden of economic management is shifting. A greater reliance on fiscal policy, with its ability to make targeted adjustments to taxes and spending, will be necessary. So, too, will be supply-side reforms to lift productivity in labour and energy markets.
Central bankers have long acknowledged that interest rates are a blunt tool. They are only now discovering just how blunt. Perhaps the era of relying on monetary policy alone to guide economies is drawing to a close. ■
