Roy J. Rotheim
After almost a decade of historically unprecedented monetary policies in response to the recession of 2007–09, there is now a growing concern among central banks that their economies are pushing ever closer to a longer-run trajectory with narrowing output gaps, low levels of unemployment, and inflation rates broaching the benchmark 2 per cent ceiling. This evidence is signalling to them that the time is ripe for policy normalisation, compelling them to restrain those accommodative monetary policies with higher nominal interest rate targets and to demonetise their balance sheets swelled by successive rounds of quantitative easing. The US Federal Open Market Committee (FOMC) began this policy shift in December 2016 with the first among now several increases in its federal funds rate policy target range. Their commitment to normalising their balance sheet was initiated with the September 2017 FOMC meeting. It is just a matter of time before other central banks follow this lead. What effect will this new direction in monetary policy have on inflation, output growth and unemployment? The mainstream theory embraced by most policy makers is that broaching the long period reflects a separation of monetary and real sectors such that monetary restraint can be expected to dampen inflation expectations and inflation, but with no effect on the natural rate of unemployment. Evidence often flies in the face of theory, and there is surely no better example of this divergence than in the extreme monetary tightening brought about by the FOMC under then chair Paul Volcker in October 1979. Volcker assured a worried public that stepping on the monetary brakes would achieve their policy goals but with no effect on the then perceived existing natural rate of unemployment. What happened, as we know, is that this exercise in extreme monetary restraint led to the greatest recession in the US since the Great Depression of the 1930s. Nominal interest rates soared, unemployment rose, although oddly enough inflation did not come down until there was a policy reversal during the subsequent year to loosen the monetary reins. Is it possible that the current and imminent move toward monetary restraint may once again not achieve the intended results expected by policy makers in terms of dampened inflation and inflation expectations with no impact on the pace of economic growth or labour demand? There is always a degree of scepticism among followers of Keynes with regard to the unlikelihood that monetary restraint will have negative employment effects. What I propose to address in this chapter is whether there may be mitigating factors on the price side of the picture that give pause to the belief held by mainstream economists (both New Classical and New Keynesian) that monetary restraint will have the predicted effects on bringing down the rate of growth of the price level. Seen from the vantage point of a more open, non-mainstream perspective, it is possible that monetary restraint may result in prices not falling, and perhaps even rising. The key factor as we explore this situation is that ongoing business activity requires a steady flow of money to finance short-term and longerterm commitments, often supported by the issuance of debt denominated in money terms. An economy is not a state, but instead an ongoing process where decisions and commitments are made in light of an uncertain future. Revenue flows in the future are uncertain to the extent that firms cannot be assured that their current and future cash flows will be sufficient to service that debt. Access to external finance must, therefore, be available at rates that will make it economically feasible to commit to the requisite contractual payment schedules. With fluctuations in output and revenue, impeded access to external finance, brought about either by central bank monetary restraint or heightened liquidity preference among banks and non-bank financial institutions, could mean the cutting back or curtailment of business operations or the necessity of selling even greater quantities of debt, thereby increasing the leverage of firms and their subsequent precariousness as creditworthy entities in the future. Production and investment flow decisions are made in the present facing an uncertain future about revenue flows. Firms who are faced with recurrent and perhaps expanded debt obligations, especially when monetary restraint may threaten the state of short- and long-term expectations with regard to revenue flows, could be forced to use their mark-ups over unit cost as a strategic variable to sustain the continued flow of finance that is becoming more costly and difficult to access through either sales revenue or external finance. To the extent that firms can engage in these defensive strategies to maintain their financial flows, monetary restraint may result in countervailing forces preventing the slowing down of prices that traditional models would suggest.