NCPA - National Center for Policy Analysis

Interest Rate Changes Take Time To Affect The Economy

January 5, 2001

The Federal Reserve cut the federal funds rate by half a percentage point on Wednesday and shaved another quarter point off the discount rate yesterday.

But it will take six months to a year for such policy switches to make their presence really felt, experts warn.

Why such a long lag-time?

  • It will take months for humans to make decisions -- such as whether to invest in stocks or new homes, or upgrade business equipment -- in response to the new interest rate environment.
  • That is true whether interest rates are rising or falling.
  • "It will take a year," explains DaimlerChrysler AG economist Wynn Van Bussman, "before the direct impact of the rate cut is felt by many companies, but you get some initial impact from expectations."
  • Some economists speculate that the lag-time could be shorter this time around because the Federal Reserve has become more transparent -- tipping off markets about its inclinations well before it changes policy.

That allows participants to adjust their policies before the Fed finally acts. Mortgage bankers, for example, began cutting interest rates months before the Fed's latest moves.

Economists will certainly have their stop-watches out this go-around, timing how long it takes for the economy to alter course.

Source: Jon E. Hilsenrath, "Lag Time is a Variable to Watch in Fed Rate Cut," Wall Street Journal, January 5, 2001.

 

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