Banks are wary of the lag between raising interest and seeing their effects
Last week saw the world’s largest central bank, the Federal Reserve, release details about its recent decision to leave US interest rates unchanged. Dubbed as the ‘Fed minutes’, these are one of the most closely watched pieces of information in financial markets. They are also highly relevant to a UK audience. The combination of the June minutes and strong US jobs data raised the expected peak for UK interest rates by a further 0.25%, to 6.5%. But it was the Federal Reserve’s discussion of lags between their recent actions and their impact that continues to vex investors, intrigue commentators, and divide economists. Lags are also increasingly cited in the UK as a reason for caution on further increases to interest rates.
First let us consider what the Federal Reserve said to the market about time lags. “[In considering its next steps] the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments”. This statement acknowledges that in raising US interest rates by five percentage points since early 2022 the US central bank has unleashed a chain reaction that will take time to play out. This lag is typically seen as taking up to two years. However, one of the consequences of near zero interest rates for much of the post-2008 era is that this transmission has not been tested in the real economy. Much of the modern global economy has radically altered in the last fifteen years and uncertainty on how this has affected transmission is keeping central bankers awake at night.
That the Federal Reserve has chosen to temporarily pause its hiking cycle whilst core US inflation is running at 5.3% a year – well ahead of its 2% price target – speaks to an uncertain understanding of modern-day lags. One can construct a respectable argument for why these lags have shortened amidst ever faster dissemination of information and data that enables households and businesses to adjust to new costs of borrowing and saving. There is also an argument that the transmission now takes rather longer as businesses have locked in lower borrowing costs. If refinancing this debt at higher interest rates is a less frequent event, then that blunts the potency – at least initially – of interest rate increases.
Turning back to the UK there are plenty of economists now focusing on the recent slowdown in the growth of money. In May broad money saw its first annual decline since 2015. Whilst the Bank of England is generally sceptical of the predictive value of money aggregates it will be part of any case for talking more vocally about lags. The problem for Governor Andrew Bailey is he is a facing off to a core inflation reading of 7.1%, and that number is still rising. Whilst he could point to dramatic falls in wholesale energy costs, global food prices – alongside this money data – as a reason to pause, he clearly fears looking tin-eared to the price growth many in the UK economy are still experiencing.
There is another aspect of the debate over lags where the UK economy has seen a dramatic change. The last time UK interest rates were at their current level, 56% of UK mortgages were on a floating interest rate. These mortgages responded immediately to changes in the policy rate set by the Bank. Today that proportion is just 13%. It means that the cumulative amount of additional interest paid by mortgage holders since interest rates began to rise is £2bn less than the additional interest accrued by savers. Later this year and into next year that relationship will dramatically reverse as more homeowners leave their fixed rate deals and refinance at higher rates. In economic terms this is when the lag will become a drag.
And this inflection point speaks to the political reality of policy lags. We know they are there. We are uncertain of their exact timing. But the ability to use them as a reason for pause in interest rate cycles hinges on the credibility of the messenger. Recent communication missteps delivered by members of the UK Monetary Policy Committee by wading into debates about pay awards and profiteering has damaged their credibility. In doing so it has limited the ability to follow the Federal Reserve in playing for time. For an increasing number of UK home and business owners that will be a costly mistake.
Published: The Times 11/07/2023
Managing Director, Head of Research