Since 2008, the Federal Reserve has kept interest rates pinned at zero, maxing out its main policy tool for stimulating the American economy following the worst recession in 80 years.
Given the disappointing nature of the recovery since then, the central bank has added unconventional monetary policy tools to the mix – foremost among them a balance-sheet expansion fueled by government bond purchases known as quantitative easing – in a bid to provide the economy with further stimulus.
Yet the effectiveness of these efforts, too, has been deemed questionable – despite several years and several trillions of dollars of bond buying, unemployment remains high and inflation remains below target – and now, the Fed is moving toward winding down quantitative easing altogether.
The reality, though, is that the effectiveness of monetary policy has actually been in decline for a long time.
Part of the reason for this decline, according to a new research paper published by the International Monetary Fund: aging in advanced economies around the world.
In the paper – titled "Shock from Graying: Is the Demographic Shift Weakening Monetary Policy Effectiveness" – IMF economist Patrick Imam links aging populations in countries like the U.S., U.K., Japan, Germany, and Canada to empirical evidence that monetary policy has become less effective.
"Based on the life-cycle hypothesis, we would expect older societies to typically have a large share of households that are creditors, and to be less sensitive to interest rate changes, while younger societies would typically have a larger share of debtors with higher sensitivities to monetary policy," says Imam.
And "with fertility rates plummeting around the world—often below replacement rate—including in low-income countries," the IMF economist writes, "the world is going through an unprecedented demographic shift that is leading to a rapidly graying world."
The paper seeks to test how much of the decline in monetary-policy effectiveness can be attributed to aging.
"The results reveal that a graying society, as measured by the old-age dependency ratio, exerts a negative (in absolute terms) statistically significant long-run impact on the effectiveness of monetary policy," Imam finds. "All else being equal, an increase in the old-age dependency ratio of one point lowers (in absolute terms) the cumulative impact of a monetary policy shock on inflation and unemployment by 0.10 percentage points and 0.35 percentage points, respectively."
Page 2 of 2 - In other words, as the old-age dependency ratio (the ratio of those in the population 65 and older to those between 15 and 64 years of age) rises, a change in policy rates by the central bank has less and less of an effect on unemployment and inflation rates.
"These estimates thus imply, when taken at face value, quite a strong negative long-run effect of the ageing of the population on the effectiveness of monetary policy," says Imam. "This is particularly significant when linked to, for instance, the projected 10 point rise in the old-age dependency ratio in Germany over the next decade."
This leads the IMF economist to a few conclusions, two of which we highlight here (emphasis added):
- More aggressive monetary policy needed: If monetary policy is less effective in a graying society, ceteris paribus, a larger change in the policy rate will be needed to bring about a change in the economy than in a younger society. This implies that traditional changes of 25 [basis points], which have been the norm in previous decades, may have to be amplified. Monetary policy will have to become more "activist" in ageing societies, with higher variation in interest rates possible going forward.
- Increasing importance of other policy tools to stabilize the economy: Monetary policy is a key tool of policymakers to stabilize the economy, and has proven to be a powerful weapon during the global crisis. If graying societies are a reason for monetary effectiveness becoming less potent, the burden to stabilize the economy and the financial system may increasingly be borne by other policy tools. With monetary policy effectiveness marginally reduced, the relative role of fiscal and macroprudential policy as a means to stabilize the economy may become more important.
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