As the above quote illustrates, the importance of monetary policy “lags” was well noted in the Minutes of the Federal Open Market Committee meeting on 1-2 November 2022, appearing no less than nine times. Stefan Gerlach explains what they are, why they arise and why the Fed pays attention to them.
The existence of lags requires central banks to look ahead in setting monetary policy: reacting solely in response to actual changes in economic conditions means that central banks will unavoidably fall “behind the curve.” Accurate inflation forecasts are therefore essential for good monetary policy, but such forecasts are often wrong and difficult to make.
Since the lags are long and many economic disturbances have merely temporary effects, often the best policymakers can do is to do nothing since economic shocks may dissipate on their own before policy becomes effective. But misinterpreting the persistence of economic shocks can have calamitous consequences. Indeed, the combination of large and unforecastable food and energy price shocks that were incorrectly judged to be temporary was one reason why central banks failed to forestall the surge in inflation that we are now experiencing.
Sources of time lags
There are several types of lags that arise when conducting monetary policy.
The first type relates to lags in recognition – it takes some for the central bank to recognise that a change in policy is warranted. These lags are often very short if a major event occurs that has obvious implications for monetary policy. The second factor concerns implementation lags – it takes some time to determine how monetary policy should respond to changes in the state of the economy. This is often straightforward if monetary policy solely involves changing interest rates. However, the introduction of unconventional monetary policy, in particular Quantitative Easing and Quantitative Tightening that involve expansions and contractions of central bank balance sheets, has made this a much more complicated task.
The third factor is policy lags – it takes some time before changes in the central bank’s policy instruments affect the broader economy. Monetary policy works in two stages. The first of these is the link between the change in policy instrument and market-determined interest rates, exchange rates and equity prices. While this link is typically very quick, it is difficult for the central bank to know how – and how quickly – financial market pricing will react to changes in monetary policy since that often depends on how market sentiment and expectations of future monetary policy change.
The second is the link between changes in financial market prices and the economy-wide demand for goods and services and, through it, inflation and growth. That step is uncertain because it depends on how households and firms interpret the changes in financial conditions and on the size and nature of their assets and liabilities.
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