Over the past 18 months we have seen central banks hike interest rates substantially and by a lot more than was expected at the outset.
Despite that, economies have avoided slipping into anything but the shallowest technical recessions (see the euro area’s two consecutive quarters of -0.1% GDP growth at the turn of the year) and underlying inflation looks stubbornly high.
So, is monetary policy less effective than it used to be? Will we need to see more hikes? Or are the lags just longer than usual? Have central banks already done more than enough to ensure substantial recessions and low inflation, but perhaps we just aren’t seeing it yet?
In my central case, I assume we are not quite at the peak for interest rates this cycle in the US, euro area and the UK. I also still assume we will see recessions later this year.
Academic views on monetary policy lags
The International Monetary Fund’s Spring World Economic Outlook flagged an analysis of studies on the timing of transmission of monetary policy to output and found that studies estimate lags of (only) between near-immediate and about three quarters for the euro area and US.
However, they also flagged an analysis of 67 studies on the lags of monetary policy tightening on the price level ('Transmission Lags of Monetary Policy', Havranek and Rusnak). While finding that it takes an average of about three years for the impact to reach its maximum, that study also found that developed economies take longer than emerging market economies and more generally that there was a large divergence in transmission lags. When they dug into the causes of those differences they found that a particularly important factor was how financially developed the country was (the more financially developed, the longer the lags). Further analysis also found that monetary transmission is slower in economies with a less independent central bank and which are less open to international trade.
Analysts expected rate hikes to cause recessions and lower inflation
Alongside the cost-of-living squeeze, monetary policy has been a key reason why many economists expected recessions this year in major developed economies:
- With inflation hitting such high levels and with labour markets so tight, there was an assumption among some economists that inflation-targeting central banks would need to generate recessions to get inflation down.
- Another related strand of argument was that, historically, central banks (generally, the Federal Reserve) haven’t had great success at engineering ‘soft landings’ (i.e. hiking rates just enough to get inflation back down to a 2% target, slowing the economy in the process but without sending it into recession).
- Some argued more generally that, given the substantial amount of monetary policy tightening we’ve seen, there was a growing likelihood that something would ‘break’.
It simply may be that more patience is required before we will see the effects of monetary policy more clearly in inflation, given the kind of lags flagged above in the price level studies for developed economies. Lower inflation feels long overdue, which partly reflects the widespread assumption that the spike in inflation would be ‘transitory’.
Why might rate hikes be taking longer to take effect?
According to the analysis highlighted above, lags (at least for prices) could be longer now if: 1) economies have become more financially developed, 2) central banks are less independent and/or 3) economies have become less open to international trade in recent years. I’d argue that there is a case to support this:
- The UK, euro area and US may not have become more financially developed, but you could argue that households and firms have been making more use of the opportunities that higher levels of financial development bring. In the UK for example, more households took out fixed rate mortgages when interest rates were low, and with longer fixed rate terms. That should have lowered households’ short-term sensitivity to interest rate increases: By the first quarter of 2023, the share of UK fixed rate mortgages was at its highest since at least 2004. More than half the UK mortgage stock has a fixed rate term longer than two years (Chart 1). As for corporates, looking beyond the UK, there was a period of sizeable US dollar high yield issuance in 2020 and 2021 that saw companies term out debt (Chart 2).
- Independent central banking is associated with central bank inflation targeting credibility more broadly. With inflation so high and following a long period of quantitative easing you can make a plausible argument that central bank inflation targeting credibility at least has been eroded. The Bank of England, for example, regularly asks consumers “overall, how satisfied or dissatisfied are you with the way the Bank of England is doing its job to set interest rates in order to control inflation?”. For the first time since the survey started in 1999, that indicator turned net negative in 2022 and was still negative in the second quarter of 2023. The European Central Bank’s (ECB’s) survey of professional forecasters showed that expectations of inflation for five years ahead moved a touch above the 2% inflation target in 2022 and have yet to move back to target (Chart 3).
- As for international trade, economies have arguably become less open to trade given the combination of Brexit, increased tariffs, sanctions against Russia and any increase in onshoring (following pandemic era supply chain disruptions). As economies potentially become less sensitive to exchange rates, monetary policy lags may get longer too as that transmission channel weakens. However, this argument only goes so far where the UK, for example, despite Brexit, remains a very open economy.
But could rate hikes also be less effective now?
One common argument is that savings/cash built up during the pandemic by households and firms have partly ‘shielded’ them – both from the impact of the cost-of-living squeeze and from higher interest rates (even if these ‘excess savings’ haven’t been evenly distributed). The build-up of deposits has also shifted the overall composition of household balance sheets. In the UK for example, the level of household deposits compared to loans is at its highest in about 20 years (Chart 4). That is likely to have softened the monetary transmission mechanism; the net impact of rising interest rates on loans and deposits may have been more positive / less negative for households than it would have been in the recent past.
On inflation, it might also be that:
- High inflation was widely assumed to be transitory, hence monetary policy may not have been tightened as far / fast as it might have done in the past in response to such stronger inflation, which might also have impacted its effectiveness;
- Relatedly, households and businesses may have become more accepting that we are in a high inflation environment after the sharp dislocation of the pandemic period. That would make it easier for firms to pass on price increases for example. Households may be more willing than in the past to accept higher services inflation after the pandemic period when those services couldn’t be accessed. However, evidence for higher inflation having become more embedded in this way is limited: US consumer inflation expectations surveys (for medium to long-term time horizons) suggest that inflation expectations may be at the upper end of their post financial crisis range, but not beyond it; the picture for the UK is similar.
All this might mean that recessions and much lower inflation are still on the way, just later
It may be that the lags of monetary policy have lengthened and that – this cycle – monetary policy is less effective than it was at slowing the economy and generating low inflation. That may mean that we are still not quite at the peak for rate hikes… but also that we will see substantial slowdowns and much lower inflation, just later.
In my central case, I assume we are not quite at the peak for interest rates this cycle in the US, euro area and UK. I also still have technical recessions pencilled in for the UK and US, alongside (eventually) significantly lower core inflation.
Chart 1: A high proportion of UK mortgages are now fixed rate and the proportion of >2-year terms has increased over time
Source: Bank of England, as at Q1 2023
Chart 2: In the high yield market, corporates termed out debt during the pandemic years
Source: BofA Global Research as at 31 March 2023
Chart 3: Professional forecasters expect the ECB to (just) miss their inflation target medium-term
Source: Refinitiv Datastream, European Commission, ECB as at May 2023
Chart 4: UK household deposits and loans
Source: ONS as at Q4 2022
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