The Federal Reserve can influence the cost of
living and a whole lot more. They do so by setting interest rates. And they only have one 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 one 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 five and 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 than one might imagine. What are the long and variable lags on the minds
of US economists, and what do they mean for your finances? The Fed's leaders often remind the public that "m
onetary policy works with long and variable lags." Let's break that phrase down. It means while it's long, it's also probably
unpredictable. Long lags basically means monetary policy is not
instantaneous. It's longer for two reasons. Number one, 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've got to do more of
it and 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 want to go
out and have a drink at the bar. That's that's something where the Fed's working
to slow down that service sector. And that's where the inflation remains. 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 lags hit versus
prior cycles. Other explanations include the overhead cost of
responding to policy changes, sticky prices and wages, the use of contracts and
business or plain old fashioned habits that are hard to
break. So we have just a number of dynamics going on in
the US economy that create some uncertainty as 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 terme 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, you know, 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 one has to understand that the
fed, they may look like they're being inconsistent, when in fact what they're doing is
reacting to, you know, a changed outlook. Financial markets in many ways, they move faster
than ever, just given how easy it is to transmit information today. But while the information may transmit very
quickly, it still takes time for the effects of of higher or lower
interest rates to impact actual economic activity and those
borrowing decisions.

The layoffs and 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. 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. Some experts think that will only have mixed
effects on productivity. Productivity can come through a lot of different
channels, so one is just better human capital. One 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. 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 you never get
them back.

And what the San Francisco fed paper says is that
there was a a longer time cost to to having to fight inflation. And so it's bad in the short tum because we worry
about unemployment. We worry about recessions. It's been a long time because that's where
increases in your wages come from. You want to be more productive. 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, you know, how difficult it is to do
forecasting. Plus the unknown impact of sort of getting rid of
all those securities.

And 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, you know, 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 expectations. 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
and once it gets embedded, you have no good choices.

You either live with the inflation and no one
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. If I listen to the policymakers, you know, they
may, depending on how the data play out, feel that 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 the meetings, it's impossible to know if they're actually done with those tightenings..

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