Monetary Policy, the Financial Cycle and Ultralow Interest Rates

65 Pages Posted: 15 Aug 2016 Last revised: 13 Jan 2018

See all articles by Mikael Juselius

Mikael Juselius

Bank of Finland

Claudio E. V. Borio

Bank for International Settlements (BIS) - Research and Policy Analysis

Piti Disyatat

Bank for International Settlements (BIS)

Mathias Drehmann

Bank for International Settlements (BIS)

Date Written: August 10, 2016

Abstract

Do the prevailing unusually and persistently low real interest rates reflect a decline in the natural rate of interest as commonly thought? We argue that this is only part of the story. The critical role of financial factors in influencing medium-term economic fluctuations must also be taken into account. Doing so for the United States yields estimates of the natural rate that are higher and, at least since 2000, decline by less. As a result, policy rates have been persistently and systematically below this measure. Moreover, we find that monetary policy, through the financial cycle, has a long-lasting impact on output and, by implication, on real interest rates. Therefore, a narrative that attributes the decline in real rates primarily to an exogenous fall in the natural rate is incomplete. The influence of monetary and financial factors should not be ignored. Exploiting these results, an illustrative counterfactual experiment suggests that a monetary policy rule that takes financial developments systematically into account during both good and bad times could help dampen the financial cycle, leading to higher output even in the long run.

Keywords: natural interest rate, financial cycle, monetary policy, credit, business cycle

JEL Classification: E32, E40, E44, E50, E52

Suggested Citation

Juselius, Mikael and Borio, Claudio E.V. and Disyatat, Piti and Drehmann, Mathias, Monetary Policy, the Financial Cycle and Ultralow Interest Rates (August 10, 2016). Bank of Finland Research Discussion Paper No. 24/2016, Available at SSRN: https://ssrn.com/abstract=2823454

Mikael Juselius (Contact Author)

Bank of Finland ( email )

P.O. Box 160
Helsinki 00101
Finland

Claudio E.V. Borio

Bank for International Settlements (BIS) - Research and Policy Analysis ( email )

CH-4002 Basel, Basel-Stadt
Switzerland

Piti Disyatat

Bank for International Settlements (BIS) ( email )

Centralbahnplatz 2
Basel, Basel-Stadt 4002
Switzerland

Mathias Drehmann

Bank for International Settlements (BIS) ( email )

Centralbahnplatz 2
CH-4002 Basel
Switzerland

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