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, may agree with those who attribute this decline to excessively low interest rates. (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 lowered 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 in favor of exporters, so much the better.
This strategy included known risks. The minutes of the Federal Open Market Committee meetings raise concerns about housing prices and the exploitation of their real estate holdings as early as 2001. Charles Kindleberger, famous financial historian and author of Manias, Panics and Crashes, has spent the end of his life "cutting the 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 raise asset prices to stimulate demand … Macroeconomic imperatives are likely to offset any threat to financial stability or stability long-term economic growth resulting from accommodative policies.
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 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.
Andrew Harrer / Bloomberg
John Williams, Fed career economist, who recently chaired the San Francisco Fed and will soon be one of the world's largest monetary policy makers when moving to New York, n & # 39 not much commented on this question. However, he is well 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 subtracting inflation.
The model that he developed with his fellow economist, Thomas Laubach, requires an estimate of "potential" economic output, defined by the level of gross domestic product consistent with a stable inflation rate. consumer price. (If this definition is reasonable, it is an issue tomorrow.) If GDP exceeds this theoretical threshold, the policy is by definition too vague. If the GDP is below Laubach-Williams' definition of potential output, the Fed must be too tight.
Comparing real GDP with their definition of potential over time and tracking these movements relative to the actual level of the federal funds rate, Laubach and Williams can estimate the "natural" rate in accordance with a policy orientation quite just.
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 four-quarter moving averages:
The chart should not be understood as an internally consistent counterfactual, but rather as a series of snapshots of what the Fed's policy should have been at some point had the central banks had a complete knowledge of the future, according to Laubach and Williams
For example, the model implies that inflation would not have become uncontrollable in the 1970s if the Fed had been much more aggressive in raising interest rates in the 1960s. That would have Avoided the need for the Volcker recession of the early 1980s and the low interest rates that the Laubach-Williams model implies 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 if this interpretation was correct or if 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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