Monetary policy may have a longer lag than we thought
Today is Fed day (again), so I leave you with my last serious post of the year. There will be the usual Christmas edition coming up on 21 December, but otherwise, I am off for the rest of 2022. I wish you all a merry Christmas, happy Hannukah or whatever holidays you celebrate. And of course, a happy 2023, may it be better than 2022 was.
Throughout this year, the monetary tightening of central banks has been the main driver of stock market returns. Yet, inflation has been creeping up to levels most forecasters (including this one) have not expected. The Fed remains adamant that in the face of weakening economic output, it still needs to hike interest rates to get inflation under control.
But while most forecasters have been underestimating the inflationary pressures in 2022, the Fed may have been underestimating the lag with which monetary tightening influences inflation and the economy. Traditional wisdom has it that it takes about 9 to 12 months for interest rates to influence inflation. Thus, the rate hikes of January this year should start to influence inflation about now, while in 2023 we will feel the impact of the rapid hikes from summer and autumn.
But a new study from Michael Bauer and Eric Swanson re-examined influential studies on the impact of monetary tightening and concluded that monetary policy might act on the economy at even longer delays than we previously thought.
Below is the estimated impact of a 25bps rate hike on industrial production (IP, top row) and inflation (CPI, bottom row). The results are shown for different time periods used in previous influential papers. The horizontal axis shows months after the rate hike. Note that while industrial production declines by about 0.5 percentage points in the 9 to 12 months after a rate hike, inflation typically bottoms after two years or later. Only when we exclude the data from the 1970s and thus the oil shocks that are like the oil shock, we saw this year do we get an inflation reaction after 9 to 12 months (right column in the chart below).
Impact of 25bps rate hike on the US economy
Source: Bauer and Swanson (2022). Note: IP = industrial production, CPI = inflation. The horizontal axis shows months after a 25bps rate hike.
In other words, models that are calibrated on the time after the 1970s inflation may overestimate how fast inflation declines in response to monetary tightening. Adjusting for all kinds of technical and statistical effects in those previous studies, Baur and Swanson estimate the reaction of industrial production, inflation, and other economic variables to a 25bps rate hike. The chart below shows their main result, and it is almost frightening.
Remember that the first rate hike by the Fed was in January this year. As the chart below shows, this rate hike reduced industrial production by about 0.4 percentage points in October/November. What we are starting to feel now in the economy are the rate hikes from the spring of 2022. If we look at unemployment rates, these should only begin to rise now or in the first quarter of 2023. The labour market strength of 2022 was no reason for the Fed to hike interest rates and it is no reason to expect a soft landing as I have explained here.
Impact of 25bps rate hike on the US economy
Source: Bauer and Swanson (2022). Note: IP = industrial production, unemp = unemployment rate, Pcomm = commodity prices, CPI = inflation. The horizontal axis shows months after a 25bps rate hike.
Even more important, commodity prices should be considered the canary in the coal mine when it comes to the impact of interest rate hikes. The chart above shows that commodity prices are the first to decline after a rate hike and they decline some 6 to 9 months after a hike. The weakness in metals and oil prices we have seen throughout autumn should be a warning of worse things to come in 2023 because they reflect essentially the first few rate hikes in 2022. The massive rate hikes of summer and autumn will only influence commodity prices in Q1 2023.
But most importantly, the impact of rate hikes on inflation unfolds not just 9 to 12 months after as conventional wisdom has it. The chart above shows that after an initial decline in inflation 9 to 12 months after a rate hike, inflation continues to decline for the subsequent 2 to 5 years. As we head into 2023, we will start to increasingly feel the impact of the rate hikes of 2022 and inflation will likely be pushed down faster and faster. But what this study shows is that the rate hike bonanza of 2022 will probably suppress inflation well into the second half of this decade. This could become a serious problem and creates the risk of a deflationary spiral as we head into a recession. Central bankers today may not only underestimate how much they have overshot their target with the rate hikes of 2022 but how much damage they have done for the next three to five years. The only way to undo that damage is to cut interest rates again, and I think when and how to do that will be a major topic for 2023.