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Date: 2024-07-27 Page is: DBtxt001.php txt00024218

US ECONOMY
ROLE OF INTEREST RATES
Has the U.S. Economy Become Less Interest Rate Sensitive?

Has the U.S. Economy Become Less Interest Rate Sensitive?

By Jonathan L. Willis and Guangye Cao

Over the past three decades, the U.S. economy seems to have become less responsive to monetary policy. Slow recoveries followed recessions in 1990-91, 2001, and 2007-09, a contrast to the much more rapid recoveries that followed pre-1990 recessions. These slow recoveries occurred despite sizeable monetary accommodation from the Federal Reserve, primarily through reductions in short-term interest rates.

This article investigates shifts in the economy’s interest sensitivity by examining how total employment responds to changes in monetary policy. The Federal Open Market Committee (FOMC) has emphasized the important link between monetary policy and employment. For example, in September 2012, the FOMC announced its intention to provide additional monetary policy accommodation on an open-ended basis that would continue as long as “the outlook for the labor market does not improve substantially.” While this implies a direct transmission channel between monetary policy and employment, the empirical analysis in this article suggests aggregate employment has become less responsive to monetary policy in recent decades.

The responsiveness of employment to monetary policy could have diminished for three reasons. First, the shift could be a result of changing behavior of monetary policy makers. Numerous researchers have Jonathan L. Willis is a vice president and economist at the Federal Reserve Bank of Kansas City. Guangye Cao is a research associate at the bank. This article is on the characterized monetary policy in the past three decades as following an active (systematic) approach compared with the passive approach of the 1960s and 1970s (Clarida, Gali, and Gertler). Second, the shift could be due to innovations in financial markets and changes in governmental regulation of the banking industry. Monetary policy works by influencing market interest rates. Studies have suggested that developments in financial markets have weakened the relationship between interest rates and firm and consumer activities (Dynan, Elmerndorf, and Sichel). Third, the shift could be due to changes within and across industries. For example, changes in the relative sizes of industries may affect the overall interest sensitivity of the economy as interest-sensitive sectors, such as durable goods manufacturing and construction, have contracted, and less interest-sensitive sectors, such as the private serviceproviding sector, have expanded. Supply-side structural shifts occurring within individual industries over the past several decades, including changes in technology and capital intensity, may also affect interest sensitivity. And on the demand side, each industry’s customers may now respond differently to changes in monetary policy.

This article finds that the key contributors to declining interest sensitivity are structural shifts within industries and a weaker transmission mechanism between short-term interest rates and the economy. In particular, two segments of the transmission channel appear to have operated with a longer lag since the mid-1980s: the transmission from shorter-term to longer-term rates and the transmission from longerterm rates to employment. Overall, the findings suggest the decline in the economy’s interest sensitivity is not due to changes in the conduct of monetary policy but rather to structural changes in industries and financial markets.

Section I describes the interest rate channel of monetary transmission and the vector autoregression (VAR) model used to evaluate interest sensitivity. Section II assesses whether the declining interest sensitivity is specific to certain industries or more widespread. Section III uses the VAR and a structural model to examine the three possible sources of declining interest sensitivity.

The text being discussed is available at
https://www.federalreserve.gov/newsevents/speech/waller20230302a.htm
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