Central bank interest-rate increases reduce potential economic output for at least 12 years, in contrast to traditional theories of national economies that assume policy is neutral in the long run, Federal Reserve Bank of San Francisco research found.

“We find that these long-run effects develop primarily through investment decisions that ultimately result in lower productivity and lower capital stock than would be available without policy intervention,” San Francisco Fed researchers Òscar Jordà and Sanjay R. Singh, and University of California Davis professor Alan M. Taylor said in a research note published Tuesday on the bank’s website.

“These productivity effects persist for at least 12 years following a period of monetary policy tightening.”

The economists used historical data for smaller economies that pegged their exchange rate to the currency of a bigger economy to study how components of output — labor, capital and total factor productivity — respond to externally driven interest-rate changes.

Monetary-policy shocks “can slow the pace of economic activity much more persistently than is commonly believed, all other economic factors being equal,” Jordà, Singh and Taylor said.

For example, in response to a 1% interest-rate increase, real gross domestic product would be about 5% lower after 12 years than it would otherwise be, the researchers found.

The authors also looked at whether central banks can boost an economy’s capacity in the long term with lower interest rates and found “there is no free lunch.”

“That is, a central bank might not be able to undo the long-run effects on the economy’s potential by running the economy hot,” they said.

Central banks around the world have embarked on the most aggressive cycle of rate hikes in several decades to try and cool inflation that was in part driven by outsize demand as economies emerged from the Covid-19 pandemic.

The analysis offers a challenge for monetary policymakers working to keep inflation low and stable while allowing the economy to reach its growth potential.

Variations in interest rates “can have unintended lingering effects on potential growth, which may ultimately complicate the calibration of policy,” Jordà, Singh and Taylor said. 

This article was provided by Bloomberg News.