21 The Power and Limits of Monetary Policy

Central bank policies, especially those concerning interest rates, are not distant or purely technical matters. They affect people’s everyday lives in profound ways. Monetary policy is not just about managing the broader economy, it is something individuals need to understand as well.

Take mortgages, for instance. Almost every household pays one to some extent, and the amount they pay each month depends directly on the interest rate set by the central bank. Similarly, if your pension fund is heavily invested in the stock market, the future value of your retirement savings is closely tied to central bank decisions.

Understanding these policies helps people make better financial choices. Should you fix your mortgage rate for two years or five? Would a variable rate linked to the central bank’s interest rate be wiser than a fixed one? When is the right time to withdraw from your pension fund? The answers to such questions depend largely on how well you grasp the direction of monetary policy.

In short, central bank decisions influence far more than inflation or exchange rates. They shape house prices, job opportunities, economic growth, and even political and financial stability.

The first theoretical question to ask here is this: what exactly is the central bank trying to achieve when it designs these policies? The central bank has several tools at its disposal to influence markets. In the early stages of economic thought, it was widely believed that the central bank’s main role was to control the money supply and use it as a direct policy target.

However, this approach lost popularity during the 1990s. Increasingly, economists and policymakers began to argue that the central bank’s key objective should be to control inflation by setting interest rates. The reasoning behind this is straightforward: when interest rates rise, borrowing becomes more expensive, which discourages households and firms from taking loans and spending. As a result, demand for goods, services, and investment slows down, helping to ease inflationary pressures. When the economy weakens, lower interest rates have the opposite effect, encouraging borrowing and spending and stimulating growth.

Through these adjustments, the central bank can influence a wide range of economic activities, from consumer spending and housing demand to business investment and overall economic stability.

Take, for example, the early 1980s. The United States was facing runaway inflation, prices were spiralling upwards at double-digit rates, making life miserable for ordinary people. Enter Paul Volcker, the newly appointed chairman of the Federal Reserve. His solution? Raise interest rates to unprecedented levels, crossing the 20% mark. It was brutal, borrowing became impossibly expensive, businesses closed, unemployment soared, and homeowners who had variable-rate mortgages found their payments doubling. The economy plunged into a deep recession. But it worked. Inflation came down, and the U.S. entered a new era of economic stability.

This is often cited as a perfect example of contractionary monetary policy, the idea that when inflation gets out of control, you must hit the brakes hard, no matter the pain. And for years, this idea shaped economic thinking. Central banks were seen as the ultimate guardians of price stability, adjusting interest rates like a thermostat to maintain the perfect economic temperature.

But then came the 2008 financial crisis, and suddenly, the world realised that things weren’t so simple.

Before the crash, interest rates were already relatively low, and yet households had taken on massive amounts of debt. When the housing bubble burst, central banks did what they were supposed to: they slashed interest rates to almost zero, hoping to revive lending and spending. And yet, economic growth remained weak. Businesses weren’t investing, consumers were reluctant to spend, and the banks, instead of lending, were hoarding cash.

It was a moment of reckoning. If cutting interest rates was supposed to boost the economy, why wasn’t it working?

One of the reasons, as the Post-Keynesians argue, is that traditional monetary policy assumes that businesses and consumers always respond to lower rates by borrowing and spending more. But what if they don’t? What if businesses are too uncertain about the future to invest, no matter how cheap money becomes? What if households, instead of spending, decide to save because they fear another crisis?

The Japanese experience serves as a cautionary tale. Since the 1990s, Japan has faced what is known as a liquidity trap, a situation where interest rates are at or near zero, but economic growth remains sluggish. The Japanese central bank has tried everything, zero interest rates, negative interest rates, quantitative easing, but none of it has managed to bring back the kind of strong, stable growth that Japan saw in the 1960s and 70s.

Why does this matter for ordinary people? Because it challenges the idea that central banks can always fix the economy by simply adjusting interest rates. If Japan’s experience teaches us anything, it’s that monetary policy has limits. And when it fails, we need to look beyond interest rates and towards other solutions.

This brings us to another critical question: if monetary policy is not always effective, what happens next?