RDP 8903: The Relationship Between Financial Indicators and Economic Activity: Some Further Evidence 6. Conclusions

On the basis of the results, there is further support for the notion that measures of economic activity lead the broader lending/credit aggregates, which was an important conclusion of BMS. No consistent leading or lagging relationship for the narrower aggregates could be found using this methodology.

The other important conclusion drawn tentatively in BMS, was that the level of short-term interest rates was consistently related to movements in economic activity, with a lag, in episodes of changing interest rates.

There is no strong statistical support for this proposition on the basis of the techniques used here. BMS found a strong negative correlation between the level of the bill rate and subsequent growth in PFD. Equally, a simple linear regression of PFD on lags of the bill rate would reveal significant negative coefficients. But the tests in the present paper look for that information to be found after past values of PFD itself are included; this is a more difficult test to pass.

It is noteworthy that while BMS observed that each major period of weakness in PFD was preceded by a big rise in the bill rate, that rise in turn came during a period of very strong growth in PFD: “boom” conditions provoked rising interest rates. In addition, the bill rate kept rising for a quarter or two after the growth of PFD initially slowed. A possible reconciliation of the observations of BMS with the results in the present paper is that interest rates responded, partly through market forces, but at least partly because of a monetary policy reaction as well, to the growth of domestic demand, and in so doing affected the subsequent growth of the economy. Part of that reconciliation would also have to be that monetary policy changed course only when it was clear that the economy had already done so. In that case, tests such as those employed in this paper would be unlikely to support a view that interest rates are “exogenous” in a statistical sense. Nor would there be much hope for finding precise estimates of the response of the economy to monetary policy changes, at least using these techniques, since policy changes themselves are related to earlier developments in the economy, and effects may be limited only to changes greater than some (unknown) threshold.

A disentanglement of these processes is probably required for a full understanding of the effect of monetary policy on the economy. In principle, techniques with very general lag structures, such as those in this paper, should allow something to be said about two way “causation”. The fact that the results here do not allow much to be said may indicate that the responses are not systematic – the lags both in changing monetary policy and in its taking effect may be variable – or that the world does not work in linear fashion. At the very least, it suggests that the structure underlying the reduced forms that make up the VARs is not well understood.

Under the maintained hypothesis that the exchange rate and short-term domestic interest rates are linked through an interest-parity condition, the results of Section 5 are consistent with a monetary policy effect on the trade sector through the exchange rate, though again it should be emphasised that these results are only preliminary in nature. Little can be said about the size and speed of this effect compared with that operating on the trade balance (in the opposite direction) through domestic expenditure. This is an important question, however, and should be the subject of continued research.