What Are Long and Variable Lags in Monetary Policy?

What are “long and variable lags” in monetary policy? Where does the idea originate? And what causes these lags to occur? In a May 2023 Regional Economist article that examined these questions, St. Louis Fed economist and Senior Economic Policy Advisor Bill Dupor began by observing that the concept of long and variable lags has featured prominently of late in the discussions of central bankers around the world about monetary policy and its impact on the broader economy.

Cause, Effect and Monetary Policy

Implementing monetary policy through changes in interest rates (which, in the U.S., usually means raising or lowering the target range for the federal funds rate) impacts elements of the economy like inflation, employment level and output growth, Dupor noted.

However, it takes some time for monetary policy actions to affect the macroeconomy—the so-called long lag.

“The lag is not only long, but it is also variable; that is, the time between cause and effect can differ from episode to episode in a way that is difficult to predict,” he wrote.

While many factors affect macroeconomic conditions, monetary policy is of particular interest because it is controlled by central banks and because it has important effects on inflation, output and employment, the author remarked.

Quantifying Long and Variable Lags

Dupor points out that economist and Nobel laureate Milton Friedman appears to have originated this concept, writing in his book A Program for Monetary Stability that “monetary changes have their effect only after a considerable lag and over a long period” and that this lag is “rather variable.”

Friedman, he explains, examined peaks and troughs in the rate of change in the money supply (the mechanism he used to describe how monetary policy was implemented, as opposed to interest rates) and in general business (what today we might associate with things like employment, consumption and real gross domestic product) over 18 business cycles in the mid-19th to the mid-20th centuries. According to Dupor, Milton found that the lag between monetary policy action and its economic effect ranged between four and 29 months, but also that there was little basis for knowing where in this range it would fall.

Two more recent estimates from U.S. central bankers put the time that it takes for changes in monetary policy to affect inflation at 18 months to two years and at nine months to a year, the author noted.

The Why Behind Long and Variable Lags

Dupor raises two potential reasons why long and variable lags in monetary policy may occur. The first involves contract length: Buyers and sellers may set prices and quantities in advance of an unanticipated change in monetary policy, in which case the new interest rate won’t influence those prices or quantities in the short run. However, he observed, a change in monetary policy would more quickly be felt in shorter-term agreements and longer-term agreements made afterward.

A second reason involves what some economists have argued is a degree of “inattentiveness” among businesses and consumers toward the overall macroeconomic environment, the author noted. For example, a firm may set prices only once a year to avoid the costs of regularly updating prices, so its prices will be unresponsive to monetary policy outside of its price-planning period, he wrote.