Context. Monetary policy has undergone a remarkable transformation over the past four years. Most central banks have quickly pivoted from aggressively easing monetary policy in 2020 to aggressively tightening it. Amid a series of global shocks, including the COVID-19 pandemic, disruptions in global supply chains, and the Russian invasion of Ukraine, concerns about inflation being too low were quickly replaced by worries about inflation being too high.
Objective. This paper provides the first systematic, cross-country analysis of “rate cycles” in 24 advanced economies over 1970-2024 in order to put today’s monetary policy challenges into context. By combining a new application of business cycle methodology with rich time-series decompositions of the shocks driving rate movements, it analyzes the characteristics of easing and tightening phases; how they have changed over time; how economic growth, employment, and inflation have evolved over these cycles; the extent to which rate cycles have been synchronized globally; and the causes of these cycles. This historical analysis, and particularly the examination of how countries have exited similar, highly synchronized rate cycles, can improve our understanding of the trade-offs currently faced by central banks. Today’s monetary policy cycle in advanced economies is unique from many perspectives, but it also shares some important similarities with cycles from earlier periods.
Differences. The post-pandemic tightening in monetary policy involved the most synchronized period of rate increases over the past 55 years. The transition from actively easing to actively tightening monetary policy was also the fastest pivot in any historical period. Nonetheless, this shift to tightening was still unusually late based on comparisons of the evolution of economic activity, labor markets, and inflation to that at the start of prior tightening episodes. The subsequent tightening phase was the most aggressive by most characteristics since the 1990s, reversing the previous trend of tightening phases becoming more muted over time. Rates have also been held constant at their peaks for longer than has occurred at the end of historical tightening phases. These unusual characteristics of the most recent monetary policy cycle reflect an equally unusual confluence of shocks starting in 2020, combined with a long-term and slow-moving backdrop of interest rates becoming more globalized since 1970. Global shocks explained about 65 percent of the variation in interest rates over 2020-23—much more than the contribution of domestic shocks for the first time. These recent global shocks included very large contributions of global supply and oil price shocks––more than double their contribution during the well-known oil price shocks in the 1970s and 1980s.
Similarities. The aggressive tightening in monetary policy after the pandemic is a reversion to historical tightening phases by most measures after unusually muted tightening phases since 2008. As in the last few years, demand shocks—both global and domestic in origin—explain the lion’s share of the variation in interest rates across most of the sample, particularly during tightening phases. While global shocks have played an increasing role in driving rate cycles since the 1970s and have become dominant since 2020, this primarily reflects a continuation of the increasing significance of global demand shocks.
Implications for monetary policy today.
- Even though central banks were slower to start the latest tightening phase of monetary policy than in past cycles (and with the benefit of hindsight), the subsequent aggressive path of rate hikes and unusually long period of holding rates constant at higher levels seems to have caught them up as most macroeconomic variables are now returning to levels (on average across our sample) typical of this stage of a tightening phase.
- Any recalibration of interest rates going forward should be gradual, taking into account domestic circumstances and the substantial uncertainty as to whether rate cycles have reverted to pre-2008 patterns. This could involve substantial divergence in when individual economies adjust rates. In the one historical precedent when several economies started easing policy before the United States following a period of a highly synchronized global tightening, there was substantial divergence in when economies began cutting rates, with the timing of rate cuts correlated with inflation rates.
- Although central bank mandates focus on domestic inflation, monetary policy decisions are likely to increasingly be influenced by global shocks. While the global shocks behind the recent swings in inflation and monetary policy were unprecedented, this is against a backdrop of a greater globalization in policy rates over time. This is unlikely to change. Policy interest rates can—and should—still diverge to reflect domestic economic conditions, but this divergence will be around a larger, shared global component.
- This increased global component in monetary policy does not necessarily imply that central banks will be responding more to global supply shocks (including oil and other commodity shocks). Instead, global shocks will likely continue to be predominantly demand shocks—as occurred during the ongoing interest rate cycle. Correctly identifying the components of global shocks that are demand versus supply is important as this decomposition could imply different monetary policy responses—with supply shocks generally requiring a more muted response (albeit subject to the characteristics of the shock and state of the economy). It is possible that overestimating the supply component of the post-2021 global shocks resulted in a slower-than-optimal response to the post-pandemic inflation. Granted, identifying global supply and demand shocks in real time is challenging, especially during periods of heightened macroeconomic volatility. Improving our ability to accurately identify these global demand and supply shocks will be increasingly crucial, however, as international factors are likely to continue to play an outsized role in the determinants of interest rates and inflation.
Citation
Please use the following when citing this paper: Forbes, Kristin, Jongrim Ha, and M. Ayhan Kose (2024). “Rate Cycles.” World Bank Working Paper, World Bank, Washington, DC.
Disclaimer
The findings, interpretations, and conclusions expressed in the working paper are entirely those of the authors. They do not necessarily represent the views of the World Bank and its affiliated organizations.
