There is a common saying in macroeconomics that monetary policy only affects the economy with “long and variable” lags. The idea being that if you cut interest rates today it might take a year - or longer - for that to result in a fall in inflation and economic output.
This notion, taken at face value, implies that most of the interest rate hikes in 2022 have barely affected the economy at all. During this week’s parliamentary testimony some asked that given these long lags why were the increases in interest rates so aggressive given that most of these supply shocks are expected to unwind themselves by the time the interest rates actually impact the economy.
But this is really only half of the monetary policy story.
There are two components to monetary policy: systematic policy frameworks (in which interest rates respond to changes in inflation and unemployment via a informal policy rule) and idiosyncratic changes to interest rates (where the central bank tweaks interest rates above and beyond the policy rule).
When economists talk about long and variable lags they are usually talking about the second component of interest rates. What happens when the RBA tweaks interest rates in one-off small amounts. They typically find that such changes have a relatively small effect that takes a long time to filter through the economy.
However, a change to the systematic component of monetary policy can have a large and sudden impact on inflation and output because it can rapidly change expectations of the future and thus the current behaviour it is conditioned on.
Imagine if instead of the nine consecutive interest rate hikes the RBA has rolled out over the past year they instead kept interest rates at 0.1 per cent. There are two ways to interpret this choice.
The RBA has repeatedly made a series of one off policy decisions to keep interest rates lower than the high inflation rate would suggest they need to be.
The RBA has fundamentally changed the way they implement monetary policy such that they either have a much higher target for inflation, or maybe do not even care about stabilising inflation at all!
The first interpretation would imply that the “long and variable” lags of idiosyncratic monetary policy would mean most of that effect is only felt in 2023 at the earliest, so we should expect to see a higher rate of inflation over 2024-25.
But the second interpretation, the RBA has fundamentally changed its approach to monetary policy, would imply that inflation might be permanently higher, affecting inflation expectations. When inflation expectations become unanchored things can get out of hand quickly and suddenly and we could see inflation soaring overnight.
Great expectations
Imagine a police station which fines people who speed too fast in order to keep the roads safe. What would happen if they decided to let people off with an occasional warning instead, if the officer thought the circumstances were appropriate?
Letting people get out of their fine with a warning once or twice probably doesn’t affect behaviour too much. People know that next time that probably won’t be so lucky and so aren’t inclined to speed even if they get off once. Looking at the data you might conclude that handing out warnings have very little impact on people's incentive to speed.
But if the police announced a policy where they would only ever issue warnings and never issue fines, then the road rules would swiftly fall apart. People would conclude that the speeding rules are a dead letter law and would drive at whatever speed they want.
If the RBA kept interest rates low they would be playing a similar game. Usually slight tweaks to the policy, whether it is speeding fines or setting interest rates, have small effects. But a systematic change in which the policymakers stop responding to high inflation or high speeding cars would quickly lead to a radical change in expectations - with wildly out of control inflation and freeways as a result.
Distinguishing what is a small tweak to policy vs a systematic change can be difficult. But keeping interest rates at 0 per cent, when inflation is at almost 8 per cent would absolutely be seen as a big break from the previous monetary policy regime.
Stuffed Turkey
A good example of the second outcome is the recent history from Turkey. At the end of 2021 President Erdogan overruled the Turkish central bank ordering it to decrease interest rates in a misguided attempt to reduce the cost of living. The decrease in interest rates wasn’t large by historical standards (see the chart below), but the nature of the political intervention and that fact that it was made in response to rising prices instantly evaporated the central bank's credibility, leading to a wild outbreak in inflation.
Turkish interest rates
Core inflation almost instantly took off and peaked at over 70 per cent! A simple economic model would never predict that a 5 per cent cut in interest rates would generate an additional 50 percentage points of inflation - (a crude, linear extrapolation of that maths would imply that the RBA’s increase in the cash rate of 3 per cent would generate 20 per cent deflation). But that is because most economic models don’t include an option for the complete collapse of the central bank's institutional credibility.
Core inflation in Turkey:
That is why the RBA needed to increase interest rates so much during 2022. Indeed they have still increased interest rates by far less than their usual policy rule would imply they should have! To do otherwise would risk sending a signal that they have given up on stabilising the inflation rate entirely - which would result in the inflation rate being permanently higher.
Maybe you think we would be immune to such effects as these sorts of collapses most commonly occur in developing countries which don’t have strong policy institutions with strong credibility.
But if Liz Truss taught us anything it’s that even a well run country can find itself in strife if it’s leaders are willing to do abandon well established policy norms for terrible ideas scribbled on the back of a napkin.