A post-mortem of interest rate policy: Beware of financial fragility

This paper argues that interest rate policy is a wrong tool to reduce inflation for two reasons. First, it ignores the causes of inflation, which started with bottlenecks in the economy, energy price shocks and some important sectors raising their profit markups. Second the financial fragility of the economy poses a serious risk, which should be solved first. We elaborate these points for the Dutch economy. This economy is characterised by several stylised facts which constitute a highly interdependent framework: (1) households with positive savings, large pension claims and a huge mortgage debt; (2) firms with large positive savings and large financial claims abroad; (3) a large financial sector with assets mainly invested in mortgages and abroad; (4) a large balance of trade surplus; (5) a Central Bank owning a large stock of Dutch government bonds; and (6) a government with modest negative savings and a moderate debt. The various interdependencies and imbalances are not sufficiently recognised in most debates on economic policy. The risks they imply for a financial crisis are also relevant for many other developed countries. In the paper we use an open economy stock-flow consistent model with a well-developed financial sector. Next to the banking sector we distinguish a pension fund which invests to a large extent abroad. Firms invest a considerable part of their retained earnings abroad in financial assets. We also introduce an inflationary process, based on conflict inflation, which allows for external inflation shocks. The model recognises the balance sheets and portfolios of financial assets of the six sectors in the model – the prices of these assets are explicitly modelled. The financial flows leading to wealth changes are analysed and both wealth effects and transmission channels for the impact of monetary policy play an important role. We estimate the model, using quarterly stock-flow consistent data for the Dutch economy. This enables us to reproduce the stylised facts presented above. From simulations with our model we show (a) why a price (and wage) policy is much more effective to reduce inflation than an interest rate policy (which mainly supresses economic growth); (b) how the vulnerability of the financial sector is aggravated by interest rate policy, and therefore can be used to blackmail central banks to reduce the interest rate.