How monetary policy affects inflation

Short video about how the policy rate influence the economy and the level of inflation

The monetary policy transmission mechanism

The way in which monetary policy affects inflation and the real economy – output and employment, for example – is referred to as the monetary policy transmission mechanism. The transmission mechanism is actually not one but several different mechanisms that act in parallel, through different channels. Some of these mechanisms affect inflation fairly directly, while others take longer to have an effect.

One common way of describing the monetary policy transmission mechanism is that it operates through the following channels:

• the interest rate channel,
• the exchange rate channel,
• the asset price channel, and
• the expectations channel.

You can read more about these channels under the respective headings below. It is important to remember that the division into different channels is an attempt to describe a complex process in which different mechanisms engage and interact. To simplify, the channels are described in a way that means they can be perceived as separate. But in practice there are strong links between the channels and it is therefore not not always obvious how to draw the boundaries between them.

Let us take as an example below that inflation is too low and that the Riksbank therefore cuts the policy rate. How does monetary policy affect inflation via the four channels of the monetary policy transmission mechanism?

Interest rate channel

The interest rate channel describes how the Riksbank can influence the interest rate situation and thus how high activity in the economy will be, which in turn affects inflation.

One aspect that is important to bear in mind when discussing the level of the policy rate is that the normal level of the policy rate is affected by the general level of interest rates. A rate lower than normal stimulates demand and inflation, while a rate that is higher has the opposite effect. The general interest rate level in Sweden is governed by the general interest rate level in the world. This has been falling for a few decades. This is not because the central banks have pursued an increasingly expansionary policy, but because global savings have been high and investment has fallen. When the supply of savings is high in relation to the demand for savings, that is, money used for investment, general interest rates fall. A fall in the general interest rate means that all interest rates, including central banks’ policy rates, fall. The normal policy rate is therefore lower today than it was a couple of decades ago. A level for the policy rate, which then had an expansionary effect on the economy, may therefore have a tightening effect today.

How does a change in the policy rate affect inflation? In this example, inflation is too low and the Riksbank therefore cuts the policy rate.

The policy rate at first affects the short-term interest rate that the central bank is trying to control. In the Riksbank’s case, this is the overnight rate, which is the interest rate paid by banks when they borrow from each other from one day to the next. Market rates with longer maturities are affected by expectations of what short interest rates will be going forward. As a result, a reduction in the overnight interest rate spreads and pushes down other interest rates in the economy, such as the banks’ and mortgage institutions’ interest rates.

For households, consuming becomes more attractive when interest rates are lower. In addition, households need to use a smaller proportion of their income for interest payments on loans. Both of these factors contribute to the consumption of more goods and services by households. For companies, lower interest rates mean that it is cheaper to finance investment and they therefore invest more in machinery and property. When households increase their consumption and companies invest more, inflation increases.

Exchange rate channel

A change in the policy rate also affects the exchange rate. When Swedish rates fall compared to rates abroad, foreign agents become less interested in investing in Sweden as it gives lower returns than investments in other currencies. This leads to lower demand for the krona (SEK). When demand for the krona decreases, its price decreases, just like the price of any product does when demand for it falls. As the exchange rate in relation to other currencies represents the price of SEK, the krona exchange rate weakens, i.e. we have to pay more SEK for a dollar or euro for example. This makes Swedish goods cheaper for households and companies abroad, which boosts demand for Swedish products, and thus increases Swedish exports to other countries. This leads to higher activity in the Swedish economy and puts upward pressure on inflation. At the same time, the prices of imported goods become more expensive in SEK, which also contributes to higher inflation.

Asset price channel

The level of interest rates also affects the prices of various assets. When interest rates are lower, it becomes less profitable to save in a normal bank account and the prices of assets, such as shares and housing, may increase. This also contributes to higher consumption, as it makes households that own such assets more willing to consume. Banks, which use the assets as collateral, may also be more willing to lend to households and companies.

Even here, it is important to bear in mind that not all movements in interest rates are due to the Riksbank changing the policy rate, i.e. its monetary policy. Changes in the general level of interest rates, and thus in the normal level of the policy rate also play a part in the development of asset prices. The fact that the general level of interest rates has fallen in a longer perspective is therefore probably an important explanation for the fact that housing prices are higher today than they were a couple of decades ago.

Expectations channel

So lower interest rates reinforce demand in the economy. Since households’ and companies’ consumption and investment today are influenced by what they think about the future development of the economy, demand can also be boosted if they expect lower interest rates going forward. The fact that the central bank cuts the policy rate and also communicates about the future level of the policy rate, for example when the Riksbank adjusts downwards its forecast for the policy rate, can therefore have a stimulating effect on the economy via expectations.

The inflation expectations of households and companies are important for the development of inflation. For example, if they expect inflation to remain high, they will adjust their price-setting and wage-setting decisions accordingly. This, in turn, fuels price increases and wage growth, leading households and companies to continue to expect high inflation, and so on. This was what happened during the 1970s and 1980s.

If they instead expect inflation to be 2 per cent, they will also adjust their price-setting and wage-setting decisions accordingly. This makes it easier for the Riksbank to maintain the target. Part of the expectations channel is therefore a question of conducting a monetary policy that anchors inflation expectations in the economy at 2 per cent.