Higher Interest Rates Can Take a Long Time to Bring Down Inflation

Lags between rate increases and real-world impacts raise the twin risks of tightening too much and too little

By Tom Fairless of The WSJ. 

When I taught, I usually covered the Policy Lag Problem. Here is how it works:

A recession begins (the economy produces less and workers are laid off) and at least 6 months later, the government finally recognizes that we are in a recession, so there is a Recognition Lag.

See Calling a Recession: How Long Does It Take? Rob Minto of Newsweek. Excerpt: 

"In 2001, the NBER declared in November the start of a recession earlier that year, but as it turned out, November 2001 was the month it also ended.

Equally, according to the NBER, the 1990-91 recession ended in March 1991, but it wasn't even declared to have begun until the announcement in April of that year."

The NBER is The National Bureau of Economic Research. They are widely recognized as the authority on dating the beginning and end of recessions.

A few months later (maybe more), the government finally decides to do something about the recession (it can take time for Congress to pass a spending bill), so there is a Decision Making Lag.

A few months later (maybe more), the government implements the spending plan (maybe Congress passed a spending bill for highways and companies have to be found, bids taken and so on), so there is an Implementation Lag.

A few months later (maybe more), the government spending finally has an effect on the economy (AD increases), so there is a Effectiveness Lag. By this time, the economy is normal or back to full-employment. Then alot of spending hits the economy. This could cause inflation. 

Excerpts from The WSJ article:

"The world’s central banks face a nail-biting wait.

They have raised interest rates this year at the fastest pace in decades. But those hikes work with what economists call “long and variable” lags so central banks might not know for years if they have tightened too much, or not enough.

Why the lag? Interest-rate changes filter through to inflation in a series of steps. The short-term lending rates controlled by central banks steer other borrowing costs in the economy, including deposit and lending rates for households and businesses, with a delay because loan contracts take time to change.

Higher borrowing costs and lower asset prices deter households and businesses from borrowing and investing, which weakens sales and the ability of companies to raise prices and workers to win raises. But it takes time to cancel projects or shed workers. Some consumers will follow through with long-planned purchases, such as a new car or kitchen. Businesses might not reduce their workforce until they feel sure that the outlook has changed.

The International Monetary Fund said this month that interest-rate changes have their peak effect on growth in about one year and on inflation in three to four years."

"A 2013 review by Tomas Havranek and Marek Rusnak of the Czech central bank of dozens of earlier papers concluded the maximum impact on inflation takes two to four years in advanced economies. In the U.K., a 1 percentage-point increase in the policy rate reduces output by 0.6% and inflation by up to 1 percentage point after two to three years, according to a 2016 paper by James Cloyne, then of the Bank of England, and Patrick Hürtgen of Germany’s Bundesbank."

"Lags create the risk that central banks might ease off the monetary brake too soon. That is because people start losing their jobs months or years before inflation returns to target, and policy makers tend to come under pressure to cut interest rates early."

"By prematurely reversing course, central banks will deliver only the pain of higher rates, with none of the benefits of low inflation, the IMF warned this month.

But lags carry the opposite risk, too: Central banks might hold interest rates too high for too long, past the point when economic output has already weakened enough and the hoped-for decline in inflation is already in the pipeline. "