Shifting monetary policy lags confuse markets and central bankers
Financial market participants have spent considerable time and resources trying to gauge the future direction of U.S. monetary policy. Yet, many have found it hard to get a clear or consistent handle on the factors influencing both market and policy interest rates. Recent spikes in uncertainty are, however, not a result of some mysterious monetary veil shrouding the actions of the Federal Reserve (Fed).
Today’s central bankers have little or no desire to appear Delphic in their public commentary. In fact, the Fed has come long a way in its communications strategy since the early days of the Alan Greenspan era. Known for his cryptic comments, former Fed Chair Greenspan once famously quipped: “I guess I should warn you, if I turn out to be particularly clear, you’ve probably misunderstood what I’ve said.” Nowadays, it is far more likely that Fed officials will “err on the side of saying too much rather than too little,” as a recent St. Louis Fed study noted.
The real problem facing both the financial and the central banking community today is the inability to ascertain the answers to two inter-connected questions. First, what is the duration of monetary policy lags? Second, have the lags shortened in recent years, and, if so, when do interest-rate changes generate their maximum impact on income and inflation?
Regarding monetary policy lags, there is a tendency to quote Milton Friedman’s famous dictum: “There is much evidence that monetary changes have their effect only after a considerable lag and over a long period and that the lag is rather variable.”
However, the significance of the rest of Friedman’s famous quote is often downplayed by the media. Citing the findings from his joint work with Anna Schwartz, Friedman goes on to state: “For individual cycles, the recorded lead has varied between 6 and 29 months at peaks and between 4 and 22 months at troughs.” The presence of considerable lag variability in these early studies indicates a heightened level of historical uncertainty associated with monetary policy.
Recently, as the Fed has engaged in a dramatic shift in its policy interest rate regime, debate surrounding the length and variability of monetary lags has once more taken centerstage. After keeping rates near-zero between March 15, 2020, and March 15, 2022, the Fed raised rates by 475 basis points between March 16, 2022, and March 22, 2023. The unprecedented nature of these moves and the unsettled nature of the domestic and global economy in the post-pandemic era have made it difficult to ascertain the potential impact of recent Fed actions on the real economy.
Even as the recent banking sector turmoil highlighted the risks associated with an unusually sharp monetary tightening cycle, there is still no clear evidence of a widespread aggregate demand slowdown that is sufficient enough to generate the economic slack necessary to bring inflation back down towards the Fed’s 2 percent target.
For many decades, academic economists have tried both to empirically identify specific monetary shocks and to establish the direction of causality (that is, decipher whether monetary policy shifts affect real income and inflation or if monetary policy is merely reacting to ongoing changes in real GDP and price levels). The task has been complicated by the difficulty in isolating the true effects of interest rate (or money stock) changes on the economy due to inherent feedback loops that run in both directions.
While faster economic growth and surging price levels will force central banks to tighten monetary policy, it is also likely that monetary contraction and higher interest rates will restrict aggregate demand and ease inflation. Further complications arise due to financial markets anticipating future Fed policy actions and constantly working to incorporate any new signals into current pricing of credit and assets. As such, the task of clearly identifying pure (or exogenous) monetary shocks and evaluating its full impact on the real economy is, to put it mildly, a tricky task.
By using better data and more sophisticated statistical tools, a new crop of researchers has been able to show that tighter monetary policy does lead to economic contraction and disinflation and that lags might in fact be shorter than previously assumed. Furthermore, recent findings suggest that lags may have actually shortened over time and maximum impact of monetary actions may in fact be felt within six to 12 months.
Increased usage of forward guidance and more transparent communication strategies are potential factors behind the shortening of policy lags. Essentially, the Fed has more and better ways to communicate its intention to financial markets. And, in theory, savvy investors can quickly and fully incorporate future policy shifts into their current decisionmaking and thus bring forward the expected changes in credit and financial conditions.
Over the past year, however, the Fed and the markets frequently appear to be at odds with each other. It is also unclear whether policy lags have shortened or lengthened of late. Markets keep expecting a quick Fed pivot even as central bankers repeatedly try to convey the steadfastness of their commitment to price stability.
Structural shifts make it hard for everyone to distinguish cyclical trends from non-cyclical ones. Central bankers increasingly appear just as puzzled as market participants and are being forced to frequently course-correct on the fly.
Vivekanand Jayakumar is an associate professor of economics at the University of Tampa.
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