Central Banks’ Influence on Interest Rates
Central banks are facing a problem that could have significant consequences for the economy. Recent academic studies suggest that central banks have a much greater influence on long-term real interest rates than previously thought. This idea challenges mainstream economic thought and could mean that basic economics textbooks need to be rewritten.
Implications of Central Banks’ Influence
If the findings of these studies are confirmed, it would support the idea that highly expansionary monetary policy may not stimulate economic growth or consumption, but rather just inflate asset prices, such as stocks or real estate. This, in turn, could widen economic inequality, with all its unfortunate consequences, including political polarization. This trend is already evident in many countries in the West.
Coincidence or Causation?
The April 2025 issue of The Review of Financial Studies features a study by Harvard economist Sebastian Hillenbrand, which documents that since the 1980s, the decline in long-term interest rates in the US has been entirely due to their movement within a relatively short, three-day window around the Federal Reserve’s monetary policy meetings. This phenomenon is not limited to the US, as similar patterns are visible in the UK, France, and Germany. The question is, could it be coincidence, or is the central bank, through its setting of short-term nominal interest rates, effectively "sealing" a development in the real economy that independently unfolds?
Self-Fulfilling Prophecy
Hillenbrand’s argument reveals that blaming central banks for these long-term rate declines is a key to unraveling these puzzles. While central banks set short-term interest rates, they also update and communicate their expectations for the long-term interest rate, notably around their policy meetings. The market adjusts to these outlooks, most intensively in the days around the meetings, and then incorporates these expectations into bond yields. If, for example, a central bank signals and communicates expectations of low inflation, low bond yields, and low interest rates, the markets tend to believe it, leading to a self-fulfilling prophecy.
Natural Interest Rate May Be Irrelevant
A study by the Bank for International Settlements explores the idea that the natural interest rate may be irrelevant from the central bank’s perspective. The authors argue that there may be no actual punishment for central banks’ arbitrary actions in practice. For example, if a central bank persistently keeps rates below the natural rate, the intended stimulative effect is only partially realized, while an unintended and often overlooked effect occurs: persistently low interest rates encourage savings and investment, reducing consumption.
Have Central Banks Made a Mistake?
The Czech National Bank’s exchange rate commitment in the past decade is a case in point. Although the CNB tried to stimulate domestic consumption and inflation by maintaining extremely low interest rates and even setting the exchange rate floor, it long failed to do so. Instead, it mainly encouraged the rise in real estate prices. If it is central banks, and not independent real factors, that determine the development of long-term real interest rates, then it must be acknowledged that their unconventional interventions over the past decade were largely or entirely a serious mistake.
Conclusion
The influence of central banks on long-term real interest rates is a complex issue with significant implications for the economy. If central banks have indeed been determining these rates, it would mean that their actions have been unnecessarily inflating asset prices, enriching the already wealthy without helping the broader economy. This would be a serious mistake with far-reaching consequences, including widening economic inequality and political polarization. It is essential to re-examine the role of central banks in setting interest rates and their impact on the economy to avoid such mistakes in the future.
