DEFINITION of Response Lag

Response lag, also known as impact lag, is the time it takes for corrective monetary and fiscal policies, designed to smooth out the economic cycle or respond to an adverse economic event, to affect the economy once they have been implemented.

BREAKING DOWN Response Lag

Response lag is one of four policy lags that make it hard for policymakers to improve the performance of the economy – and can even destabilize it. Because of recognition lag, it may take months or even years before politicians acknowledge that there has been an economic shock or a structural change in the economy. Then there is decision lag, with policymakers debating the appropriate policy response, followed by implementation lag before any fiscal or monetary policy action is taken.

In popular imagination, central banks can control the economy at will, by manipulating the money supply and interest rates. In reality, it is difficult to determine how effective monetary policy has been, never mind knowing how tight monetary policy should be. When the Federal Reserve cuts the federal funds rate, it can take 18 months before there is any evidence of that changes’ impact, and central banks can find themselves pushing on a string. This inability to fine-tune the economy, with the aim of evening out business cycles, is perhaps why every tightening cycle in the Fed's history has been followed by a recession or depression.

There are many reasons interest rate cuts take so long to affect the economy. Homeowners with fixed-rate mortgages cannot take advantage of interest rate cuts until their loans come up for refinancing, and banks often delay passing on bank rate cuts to consumers. Businesses and consumers may also wait to see if a rate change is temporary or permanent before making new investments. And if lower interest rates weaken the currency, it can take months before new export orders to be placed.

The impact of tax cuts or changes in government spending is more immediate — although they also affect the long-run trend rate of economic growth. But fiscal policies still take months to have any effect on the economy. For example, while Trump’s tax reform came into effect in January 2018, most Americans should not feel the full effects until the spring of 2019.

Other policies encourage more saving to improve productivity. A higher savings rate hits current consumption, but leads to more investment and higher living standards in the long run — according to the Solow residual. Quantitative easing has been criticized because it does little to encourage real capital investment which would improve the productive capacity of the economy.