Before everything went completely wrong, economists in the early 2000s wondered what had caused the “Great Moderation.” In the mid-1980s, swings up and down in GDP in developed economies started to become less violent. Economists describe this as “decreased volatility”—less change. A 2005 paper by Kenneth Summers for the Federal Reserve Bank of Kansas City (pdf) is typical of the explanations of the period. Monetary policy, Summers concluded, had gotten better. It was a time when the work of central banks disappeared into the quiet smugness of competence.
That time ended, we know. Bloomberg Businessweek just dedicated an entire issue to what happened. But in a recent working paper for the IMF (pdf), Patrick Imam rounds up evidence, and adds some of his own, that since the beginning of the great moderation, monetary policy has become less effective. Starting in the mid-1980s, “shocking” the interest rate—kicking it up or down at least a whole percentage point—has been having a decreasing effect on both unemployment and inflation.
Imam offers one of those beautiful explanations, so obvious in retrospect that to read it is to wonder why it isn’t already part of conventional wisdom. What central banks do in developed economies, he argues, matters less now because people in developed economies are getting older. The older you get, the more money you accumulate, and the less need you have to borrow. Franco Modigliani, an economist who won the Nobel Prize in 1985, called this the life-cycle hypothesis (pdf). You might know it as the reason your children are always coming to you for loans. Societies that borrow less are less sensitive to changes in the interest rate.
Additionally, if older households have more collateral, they pay a lower risk premium for the loans they do take out. Central bankers call this the “credit channel,” a channel being the way a monetary policy decision moves into the real economy. Households nearing or in retirement are more cautious with their investments, regardless of what the economy looks like—the “risk-taking channel.” The effect on both channels is the same. Older people have less reason to care what central banks do.
Imam doesn’t explain which channels are more important, only that a significant broad correlation exists, in developed economies, between older citizens and a less effective monetary policy. Central banks can draw a couple of lessons, he says. Monetary policy can be more aggressive, moving interest rates beyond the traditional nudges of 25 basis points. Or governments might look to fiscal policy or macroprudential regulation to do what we’ve come to rely on central banks to do. It’s hard to believe, after a major presidential candidate accused the Federal Reserve chairman of treason, that the Fed may be slowly becoming less of a big deal.