The monetary lag effect refers to the time between implementing a monetary policy and its impact on the economy.
The impact of monetary policy actions is not immediate and typically requires time to permeate the economy. First, policymakers must identify a problem. Then they need to agree on an appropriate response and implement a plan. Finally, the action must influence economic behavior. All of these stages involve a considerable amount of time. Economists refer to this delay as the monetary lag effect. A change in interest rates may take several months to influence employment, inflation, and economic growth. It takes time for businesses and individuals to adjust their investment, consumption, and borrowing patterns in response to a change in interest rates or the money supply.
The danger associated with micro-managing the economy using monetary policy is that by the time the policy’s impact is felt, circumstances may have changed, rendering the policy counterproductive. For example, inflation rose to unacceptable levels following the COVID-19 pandemic. Between March 2022 and May 2023, the Federal Reserve raised its benchmark rate ten times. Its target rates rose from 0.25% and 0.5% to 5.0% and 5.25%. During the period, the PCE price index rose to 7.0% in June, but subsequently declined to 4.4% by April 2023, which was well above the Fed’s target inflation rate of 2.0%. The initial rise in inflation illustrates how initial rate hikes did not immediately reduce the price level. The lag effect complicated the decision-making process for the Fed. Many economists argued that the Fed had raised rates sufficiently and any further increase would push the economy into a recession. Conversely, others advocated for continued rate hikes since inflation remained too high. Policymakers chose to pause and assess the impact of previous rate increases.
The duration and significance of the monetary lag effect can vary based on several factors, including the nature of the policy change, the state of the economy, and the effectiveness of policy transmission mechanisms. Economist Milton Friedman concluded that these lags could last anywhere between four and 29 months, and because of that, he said, “I find it virtually impossible to conceive of an effective procedure when there is little basis for knowing whether the lag between action and effect will be four months or 29 months or somewhere in between” (A Program for Monetary Stability, Fordham University Press, 1960). Friedman also concluded that the Federal Reserve’s use of contractionary monetary policy worsened the Great Depression. Therefore, policymakers must carefully consider these lags and anticipate their effects when formulating and adjusting monetary policy.