Long and Variable Lags
Monetary policy is now said to be “data dependant”, thought the precise meaning of that phrase isn’t clear. After its latest interest rate hike on June 29, for example, the Federal Reserve offered the following guidance: “The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.”
Linking “the outlook” to “incoming information” implies a process of hypothesis testing. Expectations of the economy’s performance are compared with the ongoing data-stream to evaluate how well forecasts are holding up. If growth or inflation exceeds expectations, then, expectations may be recalibrated, monetary policy fine-tuned, and the process continues onward.
Fair enough. But too much of a focus on the here-and-now can be problematic given what monetarist guru Milton Friedman described as the “long and variable lags” between policy actions and their consequences. The enclosed chart, for example, shows the relationship between the index of coincident economic indicators – a broad measure of economic activity – and lagged changes in the federal funds rate since 1960. In this simple approach, interest rate impacts start after four months and peak at 22 months.
That’s not too different from the findings of our Fed chairman. In a 1995 paper with far greater statistical sophistication, Bernanke concluded that “GDP begins to decline about four months after a tightening of monetary policy, bottoming out about two years after the shock.” More recently, in one of his final speeches before resigning, Philadelphia Fed president Santomero said, “It takes 6 to 18 months for monetary actions to fully impact the economy.”
With the advantage of 20-20 hindsight, recent history provides instances when an excessive policy on the near-term probably had unintended consequences. In the autumn of 1998, for example, the failure of a large hedge fund and a Russian default prompted the Fed to cut its federal funds rate by three-quarters of a point, citing “unsettled conditions in financial markets.” But one-year later the already over-valued stock market zoomed into the stratosphere, becoming what is now widely agreed to have been a bubble.
Another example comes from the summer of 2003. Then, concerned about “an unwelcome substantial fall in inflation,” the Fed pushed its overnight rate to a low 1%, even while acknowledging that “recent signs point to a firming in spending, markedly improved financial conditions, and labor and product markets that are stabilizing.” One year later the housing market was in its fourth year of record sales volume with price increases accelerating precariously.
Interestingly, this may be one dimension of economic policy where the U.S. could actually learn something from the Europeans, who take a far less active approach. Since the birth of the European Central Bank in 1999, its inter-bank rate has averaged close to the U.S. rate, though its variability (e.g. standard deviation) has been half that in the U.S. yet its growth and inflation record have been every bit as stable.
