MNI POLICY: Fed Worried Shorter Lags Require More Tightening

Federal Reserve officials are increasingly worried lags from monetary policy have shortened compared to past interest rate hiking campaigns, raising the specter that the central bank’s aggressive tightening to date has already largely taken effect and is still not enough to cool the economy and tame inflation.

More dovish voices on the Federal Open Market Committee have argued the full policy impact from the 500 basis points of rate hikes starting in March 2022 has yet to be felt. If they’re right, then pausing rate increases soon is a prudent course of action to give officials time to assess the magnitude of such effects.

However, if lags are shorter and past policies have already filtered through the economy, that means the Fed will have to respond to possible future signs of stubborn inflation with more rate hikes. (MNI INTERVIEW: Fed Will Likely Hike Rates Above 6%-Plosser)

One key difficulty in assessing the length of interest rate lags is that the Federal Open Market Committee had not hiked this rapidly since the Great Inflation of the 1970s -- or from such an accommodative stance. Since then, Fed messaging has become far more transparent, making it likely that financial markets react more quickly to the tighter policy stance.

In this environment, businesses and consumers tend to make decisions based on their expectations of future policy rather than past moves, officials believe.

NO SURPRISES

The housing market is a case in point. Sales activity slowed significantly even before the Fed started tightening as market rates reacted to the mere expectation of higher borrowing costs in the future. Now with the prospect of an end to increases in the fed funds rate later this year, housing is already showing signs of a solid rebound.

“By instantly pricing in future policy, promised rate hikes immediately affect many of the costs of financing for households and firms, even though the actual policy rate hasn't moved. As a result, policy tightening occurs with the announcement of policy tightening, not when the rate change actually happens,” Fed Governor Chris Waller said in a speech last week.

“If one believes the bulk of the effects from last year's tightening have passed through the economy already, then we can't expect much more slowing of demand and inflation from that tightening,” Waller said. The title of his speech said it all: “Big Shocks Travel Fast.”

The longer the purported lagged effects take to kick in, the less likely they appear likely to kick in at all.

“Some people say a lot of further cooling is in store from lagged consequences of the rate increases the FOMC has already made over the past year and a half,” Dallas Fed President Lorie Logan said earlier this month. “I’m skeptical about the potential for large additional effects from this channel.”

POWELL'S TAKE

Fed Chair Powell has stressed uncertainty surrounding lags, which academic research has generally pegged as somewhere between one to two years. But he appeared to lean toward the hawkish view of shorter lags when asked about it in the June press conference.

“These days, financial conditions begin to tighten well in advance of actual rate hikes,” he said, noting that Fed hints that it would soon start hiking lifted two-year note yields from 20 to 200 basis points before officials even delivered the first hike in March 2022. (See MNI INTERVIEW: Monetary Rules Say Fed No Longer Behind Curve)

“In that sense, tightening happens much sooner than it used to in a world where news was in newspapers and not, you know, not on, on the wire.”

His comments were building on similar views he expressed at the November press conference: “There was an old literature that made those lags out to be fairly long. There’s newer literature that says that they’re shorter."