Great confusion results from the widespread failure of people to understand that much time often passes between the implementation of an economic action and its results.
The Federal Reserve expands the money supply to goose economic activity and we may see near-immediate drops in interest rates. Yet the positive effects on output or consumption may not occur for a year. Ditto for the resulting rise in consumer inflation.
Respond to a pandemic by raising government spending and we might see immediate relief effects of businesses keeping people on payroll despite falling sales. Yet broader secondary and tertiary effects on prices of more disposable income sloshing around the general economy won’t show up until later.
Economists refer to these delays as “lags.”
Moreover, in the memorable phrase of Nobelist Milton Friedman, these lags are “long and variable.” As the high priest of the effects of money on economic activity and prices, the lags Friedman had in mind were of money supply changes taking any real effect. The numbers often cited are from “8 to 18 months,” or “half-year to year-and-a -half” between a change in money supply — and hence higher or lower interest rates — and the rise and fall of the production of goods, their consumption and the prices at which they trade.
Such lags are inherent and understandable, but popular pundits miss that. So when the Fed starts to increase the money supply in the face of headwinds like COVID or the Great Recession, as it did, only weeks may pass before one reads “Fed rate cuts have no effect on the economy.” But just wait a few months.
And when the Fed crimps the money supply to curb inflation, as it belatedly did in mid-March 2022, whines of “inflation remains sky-high despite Fed rate hikes” also show up within weeks, and months, and — currently — over a year.
In this case, the Fed erred in being too slow to tighten as the pandemic eased, especially since there were structural factors impelling inflation, such as snags in global supply lines.
With lag times often cited, one might not have expected much impact from the Fed’s moves on price rises or output until September 2022, at the earliest, and perhaps not even yet. But if one takes any set of months in the last half-year and annualizes the rate of change in the consumer price index, consumer inflation is pretty steady around 4.2%. That is well above what we were used to and above the Fed’s target, but less than the average of 5% over the whole decade of the 1980s, a period when we rejoiced in then-Fed Chair Paul Volcker’s slaying the inflation dragon.
A failure to appreciate such lags underlies a recent idiotic report from the Motley Fool, an investment advice publication. In breathless terms the article noted that the M2, the broader common measure of the money supply that includes currency and most bank accounts, had fallen sharply. It correctly said that absolute falls in this metric are very rare and precede recessions. The worst was in 1933, four years into the Great Depression.
While all this was true, it was completely out of context. The Fool failed to note that the Fed boosted the M2 by 27% from March 2020, when COVID first became widespread in the U.S., to March 2021. The average 12-month change over the whole rollercoaster of the past 62 years is 7.1% a year, and that for the relatively stable period of the 1980s and 1990s the M2 change was 6%. Even 19-year-old introductory macro econ students know that if the Fed increases the money supply by 27% during COVID, it could not backtrack that stimulus without decreasing the supply.
Yes, because the economy grows quite steadily and since the price level rises, the Fed can tighten money availability by slowing the growth of the nominal, or inflation-unadjusted, amount of M2 rather than actually reducing it in absolute terms. That is why pundits use the verb “constrict” rather than “cut” when referring to these changes. After an abrupt increase, unprecedented in the peacetime history of the nation, a small decrease should not surprise.
Once again, however, there are lags. The Fed just announced the latest of 10 increases for its target Fed funds interest rate, taking it from 0.25% to 5.25% over the past 13 months. This target is for loans between banks lasting from one day to the next. There are lags in how such tweaks to the money supply flow through to all types and terms of household and business lending.
It will take months for all this to work through the system. The total drop in M2 before it is all over may be larger. Yes, this often is an omen or a cause of a recession. The Fed has scrambled desperately to avoid any substantial recession since the monetary sea change that took place with the 9/11 attacks. We have had two, however. We may well have another. But it isn’t coming out of nowhere. It just takes time in economics for effects to follow causes.
Lags show up in things other than money. Economic indicators seem confusing. A long Reuters story recently highlighted Minnesota’s tight labor markets where the number of job openings per available unemployed worker is setting records, even though wages are rising.
The latest monthly labor sector reports from ADP Research, the data arm of the international payroll service company, show that pay in Minnesota is up 6.3% and that the job market is tight. Federal Bureau of Labor Statistics and Minnesota state indicators show the same, the upshot being the economy is strong and workers are scarce.
Consider two factors. First, the effects of the aforementioned large federal outlays in fiscal years 2020 and 2021 are only now fully making their effects felt in output and household spending. This, and how COVID changed how and where people work, are well reported.
Less attention is paid to the fact that we are at peak baby boomer retirements. More than 4.2 million babies were born in each of the five years from 1956 through 1961. The population was about 170 million then. It is twice that now, but we still have never again broken the rate of 4.2 million annual births. Those peak-of-baby-boom kids are now between 62 and 67 years old, right when most people leave the labor force. The population is getting older.
The labor force participation rate is the number of people 16 and over who are in the workforce as a percentage of all people over 16. It has no age cap. So as more baby boomers retire, they leave the numerator but stay in the denominator of this metric. First glances might make one think we are becoming work shy, but we are just getting older. With lower birth numbers in the 1980s and 1990s and without immigration, the labor force has to shrink.
The lag here? That the decisions couples made decades ago affect us greatly today.
St. Paul economist and writer Edward Lotterman can be reached at firstname.lastname@example.org.