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redwing

Monetary Policy Time Lag

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I've been musing about the MPC's reluctance to move interest rates at their last meeting.

One factor central banks often use to justify their decisions is that they are far more forward thinking than the rest of us. e.g.

This paper updates and extends Friedman’s (1972) evidence on the lag between monetary policy actions and the response of inflation. Our evidence is based on UK and US data for the period 1953–2001 on money growth rates, inflation, and interest rates, as well as annual data on money growth and inflation. We reaffirm Friedman’s result that it takes over a year before monetary policy actions have their peak effect on inflation. This result has persisted despite numerous changes in monetary policy arrangements in both countries.
[my bold] BoE Research Paper

and this:

Because monetary policy operates with a time lag of about two years, it is necessary for the MPC to form judgments about the outlook for output and inflation. The MPC uses a model of the economy to help produce its projections.
[my bold] Bank of England

So, the MPC should have been taking action about 12-24 months ago to head off the threat of rising inflation that we are experiencing now.

And what have they done in the last two years? Let's look:

Jun 2004 raise by .25 to 4.5

Aug 2004 raise by .25 to 4.75

Aug 2005 drop by .25 to 4.5

All other 21 decisions were to hold.

There was a sequence of raises up to Jun 2004 but it seemed to fizzle out.

More rates and graph

Questions

1. Has their policy of holds and the .25 drop last August helped to fuel the inflation they are supposed to been keeping in check?

2. And if they start raising rates now, surely it will take up to two years to bring inflation back in check. Discuss.

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So, the MPC should have been taking action about 12-24 months ago to head off the threat of rising inflation that we are experiencing now.

You are correct, but sadly only with the benefit of hindsight.

12-24 months ago, using the data and analysis common to central banks, their models did not show an expected rise in inflation, so they did not take action to counter it.

Inflation is starting to appear now, and may be higher in the future, but this has only become clear over recent months.

You can argue that the central bank models are wrong, and that they should have spotted it coming earlier, but most of the economic mainstream would have agreed with them (just look at what the implied inflation rate from bond markets has been).

Raising rates now will have a delayed impact, it is true, but that is less of a problem for two reasons:

- first, psychology and expectations are important - a rate rise now will have some immediate effects

- second, the BoE mandate is to keep inflation on target at the 2-year horizon. Shocks such as spikes in oil prices happen, and it is generally thought that central banks should not be running around responding to the latest figures and trying to keep inflation on target in the short term, as they don't have the tools and this would mean rates would be zipping up and down all the time. What matters is whether inflation is expected to come down again by around the two-year mark.

So, while with the benefit of hindsight the Bank might have liked to raise rates say a year ago, the best they can do is raise them now, and reduce inflation a year or so into the future. Unless things go really wrong (and there is no evidence they will), inflation in the interim is unlikely to rise so fast that it would cause a problem, and probably won't even break the 3% limit on the Bank's target.

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These were the market expectations, the BOE used for its forcast that showed inflation slightly above target in two years time. Therefore the bank isn't very worried about inflation (as Merve said), therefore it doesn't need to make rash choices. Merve can sit on his hands and see where retail Sales, Markets, wages, CPI all go

Market expectations2Q06	4.53Q06	4.54Q06	4.61Q07	4.62Q07	4.73Q07	4.84Q07	4.81Q08	4.92Q08	4.93Q08	4.94Q08	4.91Q09	4.82Q09	4.8

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The Fed will probably hike next week making it 17 in a row--and there is more inflation now than when they began the process. The effects of the hikes have increased mortage rates by about 1% overall yet the Fed rate has gone from 1% to 5.25%. The time lag appears to be considerable in practice.

The MPC will have to hike many times more times to see any affects also. 7% should do it nicely.

IN my view, it was blindingly obvious that inflation would plague the UK economy when you have a Chancellor who inflates house prices by more than 120% with cheap credit from Asia and then facilitates extra borrowing on top through unlimited and reckless MEW. The UK economy is, by definition, highly inflated its just that its been limited, so far, to house prices.

Edited by Realistbear

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Didn't the Bank of England expect oil prices to fall, and hence thought commodities were/are a bubble?

Yet the BoE thought it was fine to cut rates with massive M4 lending figures?

Hindsight is great, and i would have said to raise beyond 4.75% was unnesessary, but to cut rates was clearly the wrong thing to do. It goes to show that the cut in rates was partly political.

Like I've said times before, are we better off after the rate cut? I can't see how we can be. Sure, it has put economic growth back on trend, but it has made this country far more vulnerable to interest rates increases.

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In answer to your question - is there an economist in the house - NO !!!!!!

But, you have raised a very valid point - if they thought inflation was going to be a long term problem, then they would have raised IRs a few months back, when they were already predicting it would move up.

They know, that inflation is going to come back down after Xmas and that they have no need to raise IRs unless something completely unexpected comes along. So, they are going to sit and wait.

If something unexpected happens, then they may raise .... but equally, the unexpected might be such that they drop rates !!!

The probability is that rates will remain at 4.5%

Now, add to this the fact that oil has dropped back, commodities prices have dropped back, the £ continues to firm against all our competitors. The stock market has taken a dip in the short term - all these tend to be deflationary. Oh and the BoJ has put off the need to raise its IRs.

The likelyhood at the moment is that inflation will drop back faster than they were thinking, so why raise IRs, it just doesn't make sense to me.

And without substantial IR rises, you won't get your house price crash.

HPC and IR rise - not a snowballs chance in hell of either !

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In answer to your question - is there an economist in the house - NO !!!!!!

But, you have raised a very valid point - if they thought inflation was going to be a long term problem, then they would have raised IRs a few months back, when they were already predicting it would move up.

They know, that inflation is going to come back down after Xmas and that they have no need to raise IRs unless something completely unexpected comes along. So, they are going to sit and wait.

If something unexpected happens, then they may raise .... but equally, the unexpected might be such that they drop rates !!!

The probability is that rates will remain at 4.5%

Now, add to this the fact that oil has dropped back, commodities prices have dropped back, the £ continues to firm against all our competitors. The stock market has taken a dip in the short term - all these tend to be deflationary. Oh and the BoJ has put off the need to raise its IRs.

The likelyhood at the moment is that inflation will drop back faster than they were thinking, so why raise IRs, it just doesn't make sense to me.

And without substantial IR rises, you won't get your house price crash.

HPC and IR rise - not a snowballs chance in hell of either !

Gordon will be in big trouble if he raises the rates as it will be an end to No. 10. However with the Fed, ECB, BoC, BoA, BoJ, BoI, BoT, BoK all moving up the chances of Gordon being able to stand against the world are slim. And you have to remember that the economy is cyclical--put simply it means prices go up as well as down and inflated commodoties tend to go down faster than those which have risen on the back of sound fundamentals. An HPC cannot be avoided--boom and bust is built into the laws of economics. There is way to beat the system though: buy low and make sure you sell high and don't wait too long.

Edited by Realistbear

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It's amazing how things can change in just six weeks.

June's 2.5% CPI figures and all that extra borrowing on mortgages.

And then today I read the Shadow MPC votes to raise.

If the Real MPC start to tackle the current problem with inflation this month, it will take about two years before the effects will be seen.

That leaves quite a period for inflation to be getting out of hand, don't you think?

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Shameless bump of own post.

The MPC seem to me to behaving completely reactively.

They've suddenly got worried about inflation and strong GDP growth.

Their ability to look forwards seems very poor (especially in hindsight).

And according to their own web site, it is going to take the best part of two years to get things back on track.

Perhaps it's worth quoting again:

Because monetary policy operates with a time lag of about two years, it is necessary for the MPC to form judgments about the outlook for output and inflation. The MPC uses a model of the economy to help produce its projections.

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1. Has their policy of holds and the .25 drop last August helped to fuel the inflation they are supposed to been keeping in check?

House price inflation certainly.

The other inflation is energy-driven which I think means

interest rates will have a limited effect.

2. And if they start raising rates now, surely it will take up to two years to bring inflation back in check. Discuss.

Sorry to take a pessimistic stance here.

Inflation will never again be brought back in check.

It will get worse and worse and until paper money becomes valueless.

Interest rates are not going to keep a lid on energy-driven inflation.

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House price inflation certainly.

The other inflation is energy-driven which I think means

interest rates will have a limited effect.

Sorry to take a pessimistic stance here.

Inflation will never again be brought back in check.

It will get worse and worse and until paper money becomes valueless.

Interest rates are not going to keep a lid on energy-driven inflation.

If you're right, then interest rates are going to have to get nasty. After all, the economic orthodoxy on inflation is that the only tool in the box is the application of interest rates.

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In light of several other posts on the matter of interest rates I thought I'd drag up these links I posted a year ago (before the sequence of four rises started in August 06).

It's clear that the drop of .25% in Aug 05 fed the inflation problem of 18 months later.

It is going to take 12 - 24 months from the first rise in August 06 before inflation is curbed. That means we're unlikely to see the problem sorted (if at all) before the Autumn and probably more likely Spring/Summer 08.

Anyone who thinks that IRs will be peaking then falling later this year is living an illusion imo.

That means a lot of 'homeowners' facing higher mortgages as their fixed rate periods come to an end.

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Guest grumpy-old-man
In light of several other posts on the matter of interest rates I thought I'd drag up these links I posted a year ago (before the sequence of four rises started in August 06).

It's clear that the drop of .25% in Aug 05 fed the inflation problem of 18 months later.

It is going to take 12 - 24 months from the first rise in August 06 before inflation is curbed. That means we're unlikely to see the problem sorted (if at all) before the Autumn and probably more likely Spring/Summer 08.

Anyone who thinks that IRs will be peaking then falling later this year is living an illusion imo.

That means a lot of 'homeowners' facing higher mortgages as their fixed rate periods come to an end.

I was almost at the end of the thread when I realised the date on the posts. :unsure:

good one to drag back up Redwing.

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I was almost at the end of the thread when I realised the date on the posts. :unsure:

good one to drag back up Redwing.

its no wonder we don't see IMupNorth around anymore! :lol:

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Guest grumpy-old-man
The rate rises so far seem to have had little effect on money supply so far so I would expect inflation to continue to rise for some time.

fantastic!! higher inflation filtering through the system for a long period, ultimately leading to higher house price drops. :D

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The rate rises so far seem to have had little effect on money supply so far so I would expect inflation to continue to rise for some time.

Absolutely. This is the crux of the biscuit. IR policy is not short term, it's about the medium term, if one is to believe what the BoE say on their own website.

It's just unfortunate (or perhaps just weird looking) that the MPC doesn't start to put up rates until there is already Inflation creeping into the system. This was evident last June - and then it took until August for them to start putting up rates.

If this is the top of the IR cycle (with most commentators forecasting 5.75 or 6%), then it's going to take a year or two to correct the growth of the money supply, dampen down consumer spending, and bring inflation back round to target or below.

That's going to be a long period for struggling recent buyers and BTLers.

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'Why Money Supply Matters':

http://www.mises.org/story/1956

...one should not expect that changes in money supply have an immediate effect on inflation. Taking into account adjustment processes, it takes some time for the change in money supply to make itself felt in the economy. So in the following the relationship between money growth and consumer price inflation (central banks' actual "target" variable) shall be examined across three time periods: two, four, and six years. To examine the question of whether the relationship between money growth and inflation is notably close over any of these time horizons, and, if it is, how clearly that relationship holds up over shorter time horizons.

[...snip...]

The results of these admittedly rather simple analyses suggest that a relatively close relationship between money growth and consumer price inflation seems to exist at least over long time horizons in all currency areas. This finding could serve as a reminder that ignoring money growth for too long a period may be unwise when central banks aim at keeping consumer price inflation in check.

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If it takes so long for interest rate cuts to have an effect then surely the drop

in CPI from 3.0% ito 2.8% this month is a complete con?

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I think the bank of England say they expect inflation to fall later this year partly BECAUSE that is when they would expect the current series of rate rises to start taking effect. I think they generally assume rates to take about a year to feed through.

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If it takes so long for interest rate cuts to have an effect then surely the drop

in CPI from 3.0% ito 2.8% this month is a complete con?

Not really a con. There is fluctuation month by month. But remember that current CPI is generally at the upper end of the spectrum (above 1% but below 3%). The BoE shouldn't really be worried about this month's figures. What they are worrying about is that retailers, employees, distributive trades and everyone else looks at the recent high CPI figures and starts bargaining for higher prices and wages.

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CPI has been well above the 2% target for a whole year now. The MPC were expecting it to drop back to 2% that is why they did not raise rates as much as they should have done. The MPC minutes constantly refer to their inflation expectations and unfortunately the reality just did not turn out the way they expected.

Reading the MPC minutes and the BoE economic survey each month I get the sense that the MPC horizon is about 6 months ahead when considering whether to raise or lower rates but I have always felt that monetary policy takes about 18 months to actually show up in price inflation.

The problem that the MPC now face is that Sterling is weakening and they may well be forced to keep rates higher than they wish as inflation falls just to support Sterling.

Monetary, fiscal and exchange rate effects take time to filter through to the real economy (i.e unemployment and real economic growth) and a lot longer than the 6 month forecasting horizon that Mervyn King seemed to be refering to recently when talking about inflation falling back by the end of the year.

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  • 301 Brexit, House prices and Summer 2020

    1. 1. Including the effects Brexit, where do you think average UK house prices will be relative to now in June 2020?


      • down 5% +
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      • Even
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      • up 5%



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