Federal Reserve chair Jerome Powell told Congress, “We will use our tools to support the economy and a strong labor market and to prevent higher inflation from becoming entrenched.” With the Consumer Price Index up seven percent in the 12 months through December, it will soon be time for the Fed to get started. But once the Fed tightens, how long will it take for inflation to retreat?

A common rule of thumb has been a two-year time lag between monetary policy and inflation. The lag from policy to spending, production and employment is shorter, but the time lag to change inflation is long. A recent survey shows even longer time lags.

Tomas Havranek and Marek Rusnak, writing in the International Journal of Central Banking, conducted a meta-analysis of 67 published studies of the time lag. They concluded, “The average transmission lag is twenty-nine months ….” They also found the time lag to be longer, on average in developed countries such as the United States.

The actual time lags are distributed over time, with small effects felt quickly, which then build into substantial effects, and then taper off. A figure such as 29 months should be taken as the mean of the impacts.

Milton Friedman famously wrote that the time lags are both long and variable. Havranek and Rusnak found substantial variation in the studies they examined, so we should take their average time lag as suggestive rather than definitive. Friedman’s conclusion seems appropriate for forecasting: we cannot be certain what the time lag of the next tightening will be.


However, the average length of the time lags argues for high inflation for some time to come. The Fed’s stimulus was huge in March and April of 2020. That is, no doubt, driving current inflation in 2022. But 2021’s stimulus was very strong from February through November, with less stimulus—but still stimulus—planned in 2022. So 2022’s inflation is probably baked in the cake, with 2023’s inflation substantially determined by monetary policy that has already occurred.

When the Fed slows it’s purchases of long-term bonds and mortgage-backed securities, and then raises short-term interest rates a bit, inflation will appear to be unresponsive to monetary policy. The Fed, having tapped the brakes to no effect, will have to press down harder and on a sustained basis. Jerome Powell’s Senate testimony made clear that the Fed was not about to stomp hard on the brake pedal. That means that inflation will probably remain high through 2024.

Eventually the Fed will react. Powell testified that inflation exacts a toll especially on people less able to deal with “higher costs of essentials.” Whether that’s actually true or not, it is an argument that the Fed will respond to.

More broadly, people who feel good about a big pay raise also feel ripped off by higher prices at the store and gas station. Public sentiment to fight inflation will rise.

Those pesky time lags of monetary policy, however, will probably lead the Fed to wait too long (and they probably already have) and then fight inflation in a way that leaves the economy in recession. It’s not a happy outcome, and it won’t happen right away, but business leaders should prepare for a downturn in the next few years.

Source: Forbes

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