Monetary policy is widely considered as an effective tool for short-term stabilization. However, in recent decades, evidence suggests that its effectiveness in the US has been somewhat dampened. What is the reason behind this trend? Can it inform us about the relationship between monetary policy transmission and the complexity of the financial system?
In a recent paper, Alessandro Barattieri, Dalibor Stevanovic, and I document a rising trend in the fraction of financial claims which have direct counterparts in the financial sector (rather than the non-financial sector, which includes traditional borrowers such as firms, households and governments). We estimate that, up until the 1970s, close to 100% of financial assets had direct non-financial counterparts; today these traditional claims represent a mere 70% of financial assets, while the rest represent loans between financial institutions. We point out that this trend roughly coincides with the declining impact of monetary policy shocks, and propose a model that links these two trends.
The real effects of monetary policy are determined in part by the credit transmission mechanism, which works as follows: a lower nominal interest rate allows borrowers to refinance at a lower rate, raising their real net worth; this, in turn, makes them more attractive candidates for new loans, as they are more likely to repay their debt. This increase in the quality of the potential borrowers attracts more loans and more investment, which translates into more economic activity.
The responsiveness of lenders to the net-worth of borrowers is central to this transmission mechanism. However, the rise in zero-information sub-prime loans tends to suggest that lending practices have become less sensitive to the net worth of borrowers in recent years. If so, this may have been among the causes of the weakened transmission of monetary policy. Our model suggests that lending standards may become less sensitive in the presence of an active inter-bank lending market. Inter-bank lending weakens the tradeoff between liquidity and illiquid investment; consequently, banks become more likely to invest in bulk and use the inter-bank market to insure against liquidity shocks.
To summarize, our paper suggests that a structural transformation of the financial system in the US may have led to a decline in the effectiveness of conventional monetary policy. While our focus is on the US, from a development standpoint, our analysis suggests that monetary policy may be a more effective tool in countries with financial systems that engage predominantly in lending to the non-financial sectors, and less effective in countries with abundant inter-bank trading.