What Is Accommodative Monetary Policy?

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Robert Kelly is managing director of XTS Energy LLC, and has more than three decades of experience as a business executive. He is a professor of economics and has raised more than $4.5 billion in investment capital.

Accommodative monetary policy is a strategy used by central banks that is aimed at keeping interest rates low in order to infuse more cash into the economy to boost growth and maintain or reduce unemployment.

Key Takeaways

• An accommodative monetary policy is designed to keep interest rates low in order to maintain employment and infuse more cash into the economy.
• Central banks accomplish this through quantitative easing and reducing the Federal funds rate.
• Accommodative monetary policies improve employment and maintain stability after a financial crisis, but they can be bad for savers and lead to inflation.

How Does Accommodative Monetary Policy Work?

Accommodative monetary policy is a strategy used by central banks that aims to keep interest rates low in order to infuse more cash into the economy to boost growth and maintain or reduce unemployment. This policy tactic helps maintain economic stability in a time of crisis by keeping people working and helping businesses expand.

An accommodative monetary policy is often implemented during and after a crisis to provide support for the economy. The goal is to keep employment and prices as stable as possible while the situation gets resolved. While it has the major benefit of saving jobs, the low interest rates that result can hurt savers. If the policy steps are successful, the resulting strong economy could become inflationary.

The goal is to give businesses access to low-cost funds while encouraging investors to take risks that will expand the economy over time. These policies are usually managed by a country’s central bank, such as the Federal Reserve in the United States or the Bank of England in the U.K.

Examples

When a central bank decides to pursue an accommodative monetary policy, it starts by adjusting the Fed funds rate, which is the interest rate that it pays banks for deposits. The Fed directly controls this rate, making it an easy first step. A further step is quantitative easing, the act of purchasing bonds and other assets in the financial markets. When it does this, the bond owners receive cash that they in turn spend. That spending increases demand or contributes to investments in order to generate long-term economic growth.

One example of the Fed pursuing an accommodative monetary policy occurred in 2008 in response to the financial crisis. At that point, the unemployment rate was about 6.5% and rising while inflation was at about 2%. The Fed’s Open Market Committee decided to push short-term interest rates close to zero through quantitative easing to prevent a more serious economic decline.

Another example occurred at the start of the COVID-19 pandemic. In 2020, the Fed used monetary accommodation to prevent economic collapse due to the shutdown.

Note

Quantitative easing increases demand for bonds, which leads to increased prices and reduced yields.

The demand for bonds from the central bank’s purchasing activities increases bond prices, which in turn reduces the yield from the upcoming interest payments. This leads to lower interest rates for bonds. The lower rates ripple through the overall economy.

Pros and Cons of Accommodative Monetary Policy

• Investors can take more risk because of lower interest rates
• Businesses expand because of the low costs of borrowing
  

• Very low interest rates can be harmful to savers
• Policies may lead to inflation if the economy becomes too strong

Pros Explained

• Lower interest rates cause investors to take more risk: Because interest rates on government bonds and bank savings accounts are so low, investors look for riskier investments such as corporate bonds and common stock to earn a return, thus putting more money into businesses.
• Lower borrowing costs for business boosts employment: The main goal of an accommodative monetary policy is to reduce unemployment and encourage economic expansion. The quantitative easing pursued by the Fed after the 2008 financial crisis eventually led to an improved economy. By December 2015, the unemployment rate was down more than 1.5% to 5%. The Fed continued to keep interest rates low to support the labor market for several years after. It resumed an accommodative monetary policy in the early days of the pandemic, one of many factors leading to inflation as the pandemic eased.

Cons Explained

• Harmful to savers: The goal of quantitative easing is to reduce interest rates, but low rates are harmful to retirees and others who rely on fixed-income investments. If interest rates are at zero, savers either need to take risk or dip into principal. Some investors will take on additional risks in order to generate income.
• Risk of inflation: An accommodative monetary policy can also overheat an economy, generating inflation if there are more job openings than workers to fill them. In February 2022, the US had 11.3 million job openings, up from 7.9 million in 2021. Large economies are difficult to micro-manage, so quantitative easing is usually saved for financial crises in order to reduce the risks of inflation.

How Does Accommodative Monetary Policy Impact the Lives of Americans?

Monetary policy has not historically helped to close both the racial wealth gap and income gap at the same time. The Federal Reserve Bank of New York found in a study that while monetary accommodation policy reduced income inequality, it widened the racial wealth gap and caused increased inequality between people of different races.

While it can keep interest rates low to boost growth in an economy and maintain or reduce unemployment, it may cause certain groups of people to benefit more than others. For example, if White households have more money in stocks and investments than Black households, they may benefit more from an accommodative monetary policy if stocks and investments rise in price. Additionally, White households, who tend to have great wealth than Black households, may have more money in their portfolio, thus making the wealth gap even wider.