A policy-rate change doesn't hit the economy at once. It passes through four sequential stages, each with its own delay: commercial bank rates reprice in weeks; businesses and consumers then take months to adjust borrowing decisions; those decisions take further months to become real spending, hiring and construction; and that activity takes still more months to show up as measured inflation and employment. The cumulative lag from decision to full effect commonly runs well over a year — and its exact length is itself uncertain.
Reactive policy sets the rate from today's inflation reading — which actually reflects decisions made over a year ago. Pushing hard on a stale signal, then pushing hard again next month, makes the system overshoot and oscillate, like steering a ship by looking only at its wake.
Forward-looking policy sets the rate from a forecast built off the leading stages (activity that hasn't reached inflation yet), and moves in smaller steps — so it tends to settle rather than swing.
- Manual — you set the rate yourself and watch it ripple through the pipeline.
- Reactive — the model reacts strongly to the current inflation reading each month.
- Forward-looking — the model reacts gently to a forecast derived from real activity, smoothing its own rate changes.