Bank of England – Understanding the Transmission Mechanism of Monetary Policy

Prominent economist Catherine L Mann discussed the effectiveness of monetary policy and its transmission mechanism in a recent speech at the Resolution Foundation. Mann pointed out the “long and variable” lags associated with monetary policy and argued that changes in the economy and economic environment can alter the transmission mechanism. In particular, she noted that financial markets have absorbed a substantial degree of the tightening to date, but the sequence of shocks and embedding of inflation risks are leading to a troubling change in expectations formation.

Mann stressed the urgency for further tightening to ensure the effectiveness of monetary policy to achieve the objective of 2% sustainably in the medium term. She presented empirical estimates of the effect of monetary policy on macroeconomic aggregates and highlighted the importance of the functioning of individual channels and the interactions between them. The transmission mechanism works in several stages, including the transmission from a change in the policy rate through financial markets and the pass-through of changes in financial conditions to the real economy.

Mann also discussed the impact of global factors on the transmission mechanism, including changes in fiscal policy, trade linkages, commodity prices, and risk preferences. She highlighted the significance of expectations in influencing both financial and real-side channels and the role of shocks that are outside the control of central banks.

Furthermore, Mann explained the impact of monetary policy on household debt-servicing costs, mortgage rates, and equity markets. Pass-through from changes in risk-free rates to mortgage rates is highly state-dependent, and an improving economic outlook is not enough to explain equity performance.

In conclusion, Mann’s speech highlighted the complexity of the transmission mechanism of monetary policy and its influence on various factors. Her quote emphasizes the urgency for further tightening to ensure the effectiveness of monetary policy to achieve the objective of 2% sustainably in the medium term. Mann’s speech underlines the significance of understanding the transmission mechanism of monetary policy to make informed decisions that affect households, firms, and the broader economy.