L’AGEFI - Long and uncertain policy lags

Translation of an article published by L'AGEFI on 2 June, updated on 5 June 2023
By Michala MARCUSSEN, Group Chief Economist

The point that monetary policy works with long and uncertain lags is often raised in the economic debate. Some advance this argument as a reason for a policy pause, after central banks on both sides of the Atlantic have engaged one of the fastest tightening cycles on record. The fact that this policy tightening comes after a prolonged period of exceptionally low interest rates has raised concerns that new financial tremors with damaging effects on the real economy may arise. Others yet see the long policy lags as reason to further tighten monetary policy given inflation still well above central bank targets and the risk that this high inflation becomes entrenched.

The uncertainty on the monetary policy transmission links to numerous factors, be it structural changes, the situation of the domestic and international economy at the onset of the monetary policy cycle and the interaction with other economic policies. It is this later point that deserves particular attention at the current juncture as fiscal policies turn restrictive, be it in the United States or Europe.

A quick back of the envelope calculation finds that the agreement reached by President Biden and House Speaker McCarthy to suspend the debt ceiling until 1 January 2025, will likely result in a moderate drag of around 0.2pp on economic growth out to the end of 2024. This adds to an overall slightly contractionary fiscal stance, that has resulted from the unwind of the exceptional measures put in place to tackle the major shocks of the early 2020s.

Such estimates of the fiscal stance, however, struggle to account for the exceptional lags with which fiscal policy measures have operated in recent years. Indeed, much of the policy support unleased during the pandemic drove the build-up of unusual buffers on both household and corporate balance sheets. The point that this exceptional situation also brought about a period of exceptionally low bankruptcy fillings deserves particular mention, as this is an important factor contributing to low unemployment rates.

Looking ahead, we observe that several of these buffers have already been significantly reduced, be it the excess household savings or exceptional corporate profits. This means that de facto impact of cumulated fiscal policy measures may well become a more contractionary force on the economy than traditional fiscal stance estimates suggest and this at a time when monetary policy is already contractionary. Moreover, given the current political context in the United States, it would take a very substantial negative shock to be able to agree any renewed fiscal easing.

In Europe we observe a similar picture of unusual buffers fading and governments preparing to tighten fiscal policy as per the national reform programmes recently submitted to the European Commission. At the political level, the activation the activation of the “general escape clause” under the Stability and Growth Pact is due to end on 1 January 2024. This is also the time at which the European Union is due to have the new set of fiscal rules, currently under discussion, in place. 

As is the case in the United States, agreeing new significant fiscal stimulus would require a major shock. A further twist in the euro area, moreover, is that the activation of the ECB’s new Transmission Protection Instrument (TPI), that can be activated if needed to counter unwarranted bond yield spread widening, is conditional on respecting the overall fiscal framework.

In debating long and uncertain policy lags, it is thus worth recalling that these also apply to fiscal policies. Having for an exceptionally long period been leaning against monetary policy tightening, this is now changing.