People are still wondering who is responsible for the real estate debt bubble. Although there are many complementary explanations, the most controversial arguments concern the role of monetary policy. Careful analysis suggests that John Williams, the new chairman of the Federal Reserve Bank of New York, might agree with those who blame excessively low interest rates for explosions and slowdowns. (For more on his point of view, click here.)
Remember what the world looked like almost two decades ago.
In response to the triple shock of the technology crisis, the terrorist attacks of September 11 and the wave of corporate failures in the early 2000s, Fed Chairman Alan Greenspan and the majority of his colleagues reduced the key rate to 1%. They felt that low interest rates were needed to offset the effect of lower stock prices. Business investment has collapsed, consumer prices have barely risen and the labor market has stagnated. The hope was that cheap credit could restore confidence and stimulate additional household spending. If the dollar depreciates for the benefit of exporters, all the better.
This strategy involved risks and these were known. The minutes of the Federal Open Market Committee meetings raise concerns about housing prices and their extraction in 2001. Charles Kindleberger, a well-known financial historian and author of Manias, Panics and Crashes, passed the end of his life "to cut newspaper clippings that suggests a bubble on the housing market, especially on the west coast," according to a profile of July 2002.
Fed officials were also open about what they were doing, at least at FOMC meetings. The meeting of March 16, 2004 was particularly remarkable. Consider the following passage from Donald Kohn, then a member of the Board of Governors after spending years as a senior Fed official:
Political developments – and the prospect of their persistence – distort asset prices. Most of these distortions are deliberate and constitute a desirable effect of the political position. We have tried to reduce interest rates below long-run equilibrium rates and to raise asset prices to stimulate demand. […] Macroeconomic imperatives are likely to offset any threat to the long-term financial stability or economic stability of accommodative policy.
Many outside observers criticized the Fed for its policies at the time, including John Taylor of Stanford University and William White of the Bank of International Settlements. Their arguments were varied, but they all agreed that Kohn and Greenspan underestimated the dangers of the financial system and exaggerated the need for the real economy to have additional financial resources.
John Williams, Fed career economist, who recently chaired the San Francisco Fed and will soon be one of the world's most important monetary policy makers when moving to New York, n & # 39 not much commented on this question. He is however known for his research on the "natural interest rate", especially for his view that the current level of the Fed's "natural" policy rate is about 0% after subtraction. of inflation.
The model he developed with his fellow economist, Thomas Laubach, requires an estimate of "potential" economic output, defined as the level of gross domestic product consistent with a stable inflation rate. consumer price. (If this definition is reasonable is an issue tomorrow.) If GDP exceeds this theoretical threshold, the policy is by definition too vague. If GDP is below Laubach-Williams' definition of potential output, the Fed must be too tight.
By comparing real GDP and their definition of potential over time, and tracking these movements against the actual level of the federal funds rate, Laubach and Williams can estimate the "natural" rate in accordance with a policy just do it.
Most people focus on their main result, namely the decline in the basic interest rate *.
But the most interesting result is what you get by combining their estimates of the "output gap" – the gap between real and potential GDP – and their estimates of the "natural rate" in an estimate of how the Fed should set rates. There are many ways to do this, but the standard looks like this:
Optimal policy rate = natural real rate + inflation target + 1.5 * (real inflation – inflation target) + output gap
The graph below shows two versions of their implicit "implicit key rate", depending on whether you use one-sided estimates or bilateral estimates. (All data are available here.) The inflation target was set at 2%.) Both series were smoothed using moving averages over four quarters:
The chart should not be understood as an internally coherent counterfactual story, but rather as a series of snapshots of what the Fed's policy should have been at some point if central banks had had a complete knowledge of the future, according to Laubach and Williams
For example, the model implies that inflation would not have gone out of control in the 1970s if the Fed had been much more aggressive in raising interest rates in the 1960s. This would have avoided the need for the Volcker recession in the early 1980s and the low interest rates that imply the Laubach-Williams model if you start the clock in 1982.
None of this is particularly surprising. Most Fed officials would gladly tell you that the central bank was too lax in the first decade of high inflation.
The surprising result of this extension of the Laubach-Williams model is what he says about the Fed's policy in the 2000s. Their implicit policy rule suggests that the Fed was too loose by several percentage points, whether you use unilateral or bilateral estimates as inputs. According to their bilateral estimate, which fully incorporates the benefits of the pullback, the Fed should not have lowered its key rate below 3.5% – if that happens.
We explicitly asked the San Francisco Fed whether this interpretation was correct or whether Williams wanted to comment on our methodology. They said "we do not have much to add."
* The difference between unilateral and bilateral estimates is that unilateral estimates do not benefit from the decline. Bilateral estimates are therefore "more accurate" to retrospectively assess politics and the economy, but not representative of what might have been known at the time.
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