Federal Reserve leaders warned of monetary policy's "long and variable" lags numerous times in 2023. This term refers to the unpredictable speed at which interest rate changes can affect the economy. The higher borrowing costs that come with the Fed's decisions may slow economic growth for long periods of time. And in the short term, businesses and households may contend with moderately higher cost loans.

Chapters:
Cold Open: 0:00 - 01:14
Chapter 1: Lags 01:15 - 03:25
Chapter 2: When, exactly? 03:25 - 06:15
Chapter 3: Predictions 06:15 - 08:26

Produced by Carlos Waters
Animation by Christina Locopo
Supervising Producer Lindsey Jacobson
Additional Footage Getty Images
Additional Sources Federal Reserve Bank of Atlanta, Federal Reserve Bank of Dallas, Federal Reserve Bank of Kansas City, Reuters, Federal Reserve Bank of San Francisco

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Why Interest Rates Take So Long To Affect The Economy

The Federal Reserve can influence the cost of living, and a whole lot more.

And they only have 1 interest rate they control.

You push this interest rate, and then you just sort of watch.

And we have to do that in a world where policy works with long and variable lags.

When they say monetary policy operates with a long and variable lag, what they are saying is economists speak for, we have no idea.

Unexpected interest rate increases can slow the economy down for a long time, 12 years, according to 1 estimate.

So it takes time for these policy decisions to show up.

It might not all hit at once, but the longer rates stay elevated, the more you're going to feel those effects.

I think you still have this question about the lags.

Are we past peak tightening and peak lags, or are the impacts of a 5 3 8 funds rate still to be felt?

That's making the Fed's job more complicated.

That also does mean that they might be moving and switching direction more quickly than 1 might imagine.

What are the long and variable lags on the minds of U.S.

The Fed's leaders often remind the public

that monetary policy works with long and variable lags.

It means while it's long, it's also probably unpredictable.

Long lags basically means monetary policy is not instantaneous.

Number 1, globalization has affected the Fed.

Part of what used to just happen in the US is now getting spread across the whole globe.

To get any big impact, you gotta do more of it and it takes longer for that to happen.

The second thing that's going on is this isn't your father's economy.

It's harder to slow down people who wanna go out and have a drink at the bar.

That's something where the Fed's working to slow down that service sector.

Next is the variable part of the statement.

The variable part of the lag has to do, I think, with the initial position of the business and consumer sector.

In this case, it can be variable because you have the stronger balance sheets, the fact that consumers did have additional savings that we wouldn't have expected if they had continued to save at the same pre COVID rate.

And so that's giving some more insulation in terms of their need to borrow.

That's an example of why this cycle might be different in terms of when those lacks hit versus prior cycles.

Other explanations include the overhead cost of responding to policy changes, sticky prices and wages, the use of contracts in business or plain old-fashioned habits that are hard to break.

So we have just a number of dynamics going on in the U.S.

Economy that create some uncertainties to exactly how long does it take for all the effects to be felt.

Basically recognize that our economy has some sectors that have very long term debt that's outstanding and that price is set today.

There are papers that are starting to appear now that say full effect of an interest rate hike can be a decade or more has everything to do with that dynamic.

Some believe the Fed decisions may be rippling through the economy more quickly since the financial crash of 2009.

Everything that we know about modern financial transactions suggests that lag is shorter than it used to be.

The Fed is actively trying to get their policy understood in advance, so they're trying to accelerate that process.

40 or 50 years ago, it was unheard of for the Fed to be this transparent.

And so by being more transparent, maybe you make the time frame shorter.

And we've seen this cycle where the stock market moved more quickly in some cases, more slowly in other cases.

So, you know, this question of variability comes into play, as in how long it's going to take.

We think it's a long time, but sometimes it can be faster, sometimes it can be shorter.

It's the nature of this economy has changed.

That doesn't necessarily make it a problem.

It just means that 1 has to understand that the Fed, they may look like they're being inconsistent when in fact what they're doing is reacting to a changed outlook.

Financial markets in many ways, they move faster than ever just given how easy it is to transmit information today.

while the information may transmit very quickly, it still takes time for the effects of higher or lower interest rates to impact actual economic activity and those borrowing decisions.

The layoffs in corporate bankruptcy waves in 2023 indicate that interest rates may already be at work.

For example, most major banks are letting go sizable chunks of their staff.

And it has said very clearly, it is our job to get inflation under control, and we are going to keep at it until we do.

And that involves some bad news on a fairly regular basis.

Some experts think that will only have mixed effects on productivity.

Productivity can come through a lot of different channels.

So workers have better tools at their disposal.

And so from the extent that you do have higher financing costs, Higher interest rates can perhaps slow some of that investment, but a lot of times higher rates are coming in an environment where you do have a very tight labor market.

So there are some offsetting factors here.

When interest rates change and money gets more expensive, it reduces gross domestic product for years.

In each case, the consequence of the Fed's policy is to reduce improvements in productivity.

And what The San Francisco Fed paper says is that there was a longer term cost to having to fight inflation.

And so it's bad in the short term because we worry about unemployment.

It's bad in the long term because that's where increases in your wages come from.

Economists study history to predict when the effects of interest rates are taking hold.

You've heard Jerome Powell himself talk about the need for there to be modesty or humility among central bankers and talk very much about how difficult it is to do forecasting.

Plus the unknown impact of getting rid of all those securities.

So that's still working through the economy.

The Fed bought tremendous amounts of bonds from the government over the past 15 years.

Indeed, during the most recent crises, the Fed has found itself buying quite a bit of bonds.

Once the crises have ended, they then have to switch that process.

The Federal Reserve reduced its balance sheet holdings to $7.7 trillion by December 2023.

The Fed's activity here may restrict economic growth even more.

Now that's important from a lag perspective because the Fed is very clear about their plans to reduce the size of their balance sheet.

It's on a very well-telegraphed course, and so that can feed into market expectation.

But at the end of the day, you still need businesses or households to need to actually go and borrow to have those policy changes impact their own financial well-being.

What they're doing is what Federal Reserves and other monetary authorities have to do once inflation gets embedded in the economy.

Once it gets embedded, you have no good choices.

You either live with the inflation and no 1 likes that, or you do the things necessary to get the inflation under control.

But that's a steady drumbeat of worse news.

If I listen to the policymakers, you know, they may, Depending on how the data play out, feel they have to tighten a bit more.

The market is betting that they're done completely, but until the data come in and the Fed actually has a meeting, it's impossible to know if they're actually done with those tightens.


Speaker 0: The Federal Reserve can influence the cost of living, and a whole lot more. They do so by setting interest rates.

Speaker 1: And they only have 1 interest rate they control. You push this interest rate, and then you just sort of watch.

Speaker 2: And we have to do that in a world where policy works with long and variable lags.

Speaker 1: When they say monetary policy operates with a long and variable lag, what they are saying is economists speak for, we have no idea.

Speaker 0: Unexpected interest rate increases can slow the economy down for a long time, 12 years, according to 1 estimate.

Speaker 3: So it takes time for these policy decisions to show up. It might not all hit at once, but the longer rates stay elevated, the more you're going to feel those effects.

Speaker 4: I think you still have this question about the lags. Are we past peak tightening and peak lags, or are the impacts of a 5 3 8 funds rate still to be felt?

Speaker 0: That's making the Fed's job more complicated.

Speaker 2: That also does mean that they might be moving and switching direction more quickly than 1 might imagine.

Speaker 0: What are the long and variable lags on the minds of U.S. Economists? And what do they mean for your finances? The Fed's leaders often remind the public

Speaker 2: that monetary policy works with long and variable lags.

Speaker 0: Let's break that phrase down.

Speaker 2: It means while it's long, it's also probably unpredictable. Long lags basically means monetary policy is not instantaneous.

Speaker 1: It's longer for 2 reasons. Number 1, globalization has affected the Fed. Part of what used to just happen in the US is now getting spread across the whole globe. To get any big impact, you gotta do more of it and it takes longer for that to happen. The second thing that's going on is this isn't your father's economy.

It is primarily services. It's harder to slow down people who wanna go out and have a drink at the bar. That's something where the Fed's working to slow down that service sector. And that's where the inflation remains.

Speaker 0: Next is the variable part of the statement.

Speaker 3: The variable part of the lag has to do, I think, with the initial position of the business and consumer sector. In this case, it can be variable because you have the stronger balance sheets, the fact that consumers did have additional savings that we wouldn't have expected if they had continued to save at the same pre COVID rate. And so that's giving some more insulation in terms of their need to borrow. That's an example of why this cycle might be different in terms of when those lacks hit versus prior cycles.

Speaker 0: Other explanations include the overhead cost of responding to policy changes, sticky prices and wages, the use of contracts in business or plain old-fashioned habits that are hard to break.

Speaker 2: So we have just a number of dynamics going on in the U.S. Economy that create some uncertainties to exactly how long does it take for all the effects to be felt. Basically recognize that our economy has some sectors that have very long term debt that's outstanding and that price is set today. There are papers that are starting to appear now that say full effect of an interest rate hike can be a decade or more has everything to do with that dynamic.

Speaker 0: Some believe the Fed decisions may be rippling through the economy more quickly since the financial crash of 2009.

Speaker 1: Everything that we know about modern financial transactions suggests that lag is shorter than it used to be. The Fed is actively trying to get their policy understood in advance, so they're trying to accelerate that process.

Speaker 2: 40 or 50 years ago, it was unheard of for the Fed to be this transparent. And so by being more transparent, maybe you make the time frame shorter. And we've seen this cycle where the stock market moved more quickly in some cases, more slowly in other cases. So, you know, this question of variability comes into play, as in how long it's going to take. We think it's a long time, but sometimes it can be faster, sometimes it can be shorter.

It's the nature of this economy has changed. That doesn't necessarily make it a problem. It just means that 1 has to understand that the Fed, they may look like they're being inconsistent when in fact what they're doing is reacting to a changed outlook.

Speaker 3: Financial markets in many ways, they move faster than ever just given how easy it is to transmit information today.

Speaker 0: But

Speaker 3: while the information may transmit very quickly, it still takes time for the effects of higher or lower interest rates to impact actual economic activity and those borrowing decisions.

Speaker 0: The layoffs in corporate bankruptcy waves in 2023 indicate that interest rates may already be at work. For example, most major banks are letting go sizable chunks of their staff.

Speaker 1: But the Fed doesn't have a choice. And it has said very clearly, it is our job to get inflation under control, and we are going to keep at it until we do. And that involves some bad news on a fairly regular basis.

Speaker 0: Some experts think that will only have mixed effects on productivity.

Speaker 3: Productivity can come through a lot of different channels. So 1 is just better human capital. 1 is more investment. So workers have better tools at their disposal. And so from the extent that you do have higher financing costs, Higher interest rates can perhaps slow some of that investment, but a lot of times higher rates are coming in an environment where you do have a very tight labor market.

So there are some offsetting factors here.

Speaker 0: When interest rates change and money gets more expensive, it reduces gross domestic product for years.

Speaker 1: In each case, the consequence of the Fed's policy is to reduce improvements in productivity. And you never get them back. And what The San Francisco Fed paper says is that there was a longer term cost to having to fight inflation. And so it's bad in the short term because we worry about unemployment. We worry about recessions.

It's bad in the long term because that's where increases in your wages come from. You want to be more productive.

Speaker 0: Economists study history to predict when the effects of interest rates are taking hold.

Speaker 2: You've heard Jerome Powell himself talk about the need for there to be modesty or humility among central bankers and talk very much about how difficult it is to do forecasting.

Speaker 1: Plus the unknown impact of getting rid of all those securities. So that's still working through the economy.

Speaker 0: The Fed bought tremendous amounts of bonds from the government over the past 15 years.

Speaker 2: Indeed, during the most recent crises, the Fed has found itself buying quite a bit of bonds. Once the crises have ended, they then have to switch that process.

Speaker 0: The Federal Reserve reduced its balance sheet holdings to $7.7 trillion by December 2023. The Fed's activity here may restrict economic growth even more.

Speaker 3: Now that's important from a lag perspective because the Fed is very clear about their plans to reduce the size of their balance sheet. It's on a very well-telegraphed course, and so that can feed into market expectation. But at the end of the day, you still need businesses or households to need to actually go and borrow to have those policy changes impact their own financial well-being.

Speaker 1: What they're doing is what Federal Reserves and other monetary authorities have to do once inflation gets embedded in the economy. Once it gets embedded, you have no good choices. You either live with the inflation and no 1 likes that, or you do the things necessary to get the inflation under control. But that's a steady drumbeat of worse news. But the Fed doesn't have a choice.

Speaker 2: If I listen to the policymakers, you know, they may, Depending on how the data play out, feel they have to tighten a bit more. The market is betting that they're done completely, but until the data come in and the Fed actually has a meeting, it's impossible to know if they're actually done with those tightens.

Speaker 1: You

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Why Interest Rates Take So Long To Affect The Economy