Transmission of monetary policy

Monetary policy transmission refers to the mechanisms by which central banks’ policy measures affect monetary and macroeconomic variables important to the objectives of monetary policy and – in particular – inflation. In the euro area, monetary policy is conducted using a variety of monetary policy instruments. As the instruments differ from each other, their transmission mechanisms are not exactly the same either.

Monetary policy changes are transmitted to the economy via financial markets

When the central bank uses interest rate policy, i.e. conventional monetary policy, it uses its official interest rates to steer short-term interest rates, in particular. Changes in the policy rates also affect longer-term interest rates, such as the Euribor rates and government bond yields.

However, the effects of policy rate changes on long-term market rates are typically smaller than on short-term money market rates. This is because long-term interest rates are also influenced by many factors other than the central bank’s monetary policy.

Forward guidance – the central bank’s communication on its future policy decisions – is typically used to influence, in particular, interest rates with a term of a few months or years. Forward guidance is also reflected in long-term interest rates, such as 10-year bond yields, even though monetary policy communication does not extend to such a long period. Long-term interest rates are specifically influenced by the expected path of interest rates over the entire maturity of the loan. Hence, changes in expectations about the interest rates over the next three years, for example, will also impact longer-term interest rates.

Central banks may also influence the economy via quantitative easing (QE) or quantitative tightening (QT). This means that the central bank may expand or reduce its balance sheet by purchasing or selling securities of different maturities, which will affect their prices and thereby their yields, or returns.

In addition to deploying these instruments, the ECB has conducted monetary policy through targeted longer-term refinancing operations (TLTROs). In these operations, the central bank provides commercial banks with loans that have a longer term than those provided in the standard refinancing operations. Lending can be combined with incentives for banks to increase their lending to specific groups, such as businesses and households. LTROs have a particular impact on banks and bank-dependent sectors targeted by them.

Monetary policy aims to influence aggregate demand in the economy and hence the price level

Besides these immediate effects, monetary policy also affects many other variables.

The level of interest rates and changes therein affect the willingness of households and businesses to save and invest. Higher interest rates make it less attractive to take out a loan for consumption or investment purposes. They also make banks less willing to provide loans as their own funding costs increase. The incentives to save will change, which will materialise in, for example, changes in the interest rates on bank deposit accounts or in the prices of shares. This, in turn, will affect the aggregate demand in the economy.

When monetary policy is tightened, that is when interest rates rise, aggregate demand in the economy decreases. Lower demand, in turn, will ultimately slow inflation.

Changes in aggregate demand are also reflected in the labour markets. If monetary policy tightens and aggregate demand in the economy decreases, this will lead to higher unemployment and lower employment. If monetary policy is eased, consumption and investment will increase, employment will improve and the general price level will rise, meaning inflation will pick up.

Monetary policy also influences aggregate demand through household wealth. For example, changes in housing and equity prices affect household consumption and also the availability of credit via changes in the value of collateral. Monetary policy also impacts households’ disposable income via the cash-flow channel, as changes in interest rates are reflected in the interest revenues of households and interest payments by indebted households.

Central bank credibility is important

The central bank’s credible commitment to its inflation target and measures to achieve the target are key factors affecting the transmission and effectiveness of monetary policy. Commitment to the inflation target influences expected inflation, which is a key variable in, for example, wage negotiations or firms’ pricing decisions. Thus, inflation expectations ultimately affect actual inflation.

Keeping inflation expectations stable and in line with the central bank’s inflation target is of the utmost importance.

Changes in the monetary policy stance pass on to inflation gradually. Although the effects will begin to materialise fairly soon after the policy change, it will typically take several quarters until monetary policy is fully transmitted to inflation.