An Explanation So Clear Even A Maestro Could Follow It
This ten point explanation from Barry Ritholtz lays out the contribution of ultra-low interest rates to the financial crisis. Shorter version: low interest rates plus ratings agencies for sale equals enormous debacle. To his tenth point on the lax regulatory environment emanating, in his words, from the Fed, I would add the abject failure of the SEC to hold the line on investment bank leverage ratios. This report should have had a bigger impact than it did.
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Counterfactual
What should the federal funds rate have been in 2002 and 2003?
We had more than three years of rising unemployment (3.8% in Apr 2000 and 6.3% in Jun 2003), with unemployment not consistently below 2002 levels until the 2nd half of 2004, the failure of headline inflation to break above 2% YoY until April 2004 (the previous surge above 3% was probably related to energy due to Iraq War concerns), core inflation on a disinflation trend from ~2.5% in 2001 to just 1.1% by Jan 2004 (lower than the 1.3% rate today), corporate accounting scandals, war, terrorism and a large decline in financial wealth due to the stock market crash.
If you're targeting the fed funds rate in order to generate a steady rate of inflation, you don't start raising your target rate above 1% when core inflation is at 1.1% and falling, do you?
Not to saw that Barry is wrong - he's right to say that low rates were an important factor. It's simply hard to second guess the Fed's monetary policy as it was conducted at the time.
We need to consider the counterfactual of the Fed hiking rates more quickly.
Consider a proposal in Jan 2003 to hike rates from 1.25% to 3.75% over the Jan 2003 to Jun 2004 period, and to 5.25% by Jun 2005. Anyone who proposed that path of interest rates given the conditions of early 2003 wouldn't have gotten all that far - they would have been told that such a policy move would risk deflation and unemployment going above 7%. That doesn't seem so bad now, but no one had idea what the marcoeconomic landscape was going to look like in 2010. Jan 2003 was therefore too early.
What about Jul 2003? Well, unemployment had risen to 6.3% as of Jun 2003 (not sure what it was originally reported as, but that's the current data point), and core inflation had decelerated from 1.9% to 1.5%.
Perhaps Jan 2004? 2003Q3's GDP growth rate was very strong - 7 or 8% as originally reported, but that was just one quarter - the first quarter of 2002 was originally reported as a ~6% rate of growth, and that didn't amount to much. Also, core inflation was now at 1.1% over the past year - yikes! Output and employment data was becoming favorable, but it seemed prudent to wait at the time, to see if the 2003Q3 spike was really the start of a trend. If I recall correctly, there was a bit of a 'soft patch' reported in the monthly data during 2004Q2, but by mid 2004 it was clear that a strong recovery had fallen into place - core inflation had zoomed back up, and the time to hike had arrived. How quickly?
It could have been slightly faster - perhaps hitting 5.25% by the end of 2005 instead of mid 2006, but hiking 425bps over the course of 12-18 months would have been seen as very aggressive. In any case, most of the housing inflation and building levels were hit in 2005 as it was, and so a lot of the damage of low interest rates had already been done.
On the other hand, you can have very low interest rates without a housing bubble if you regulate lousy collateral and poor lending practices largely out of existence (0% down, IO loans, not checking borrower information). In fact, if by tightening regulatory standards we generated a bit more CPI inflation, there might have been more room for the Fed to hike rates. So while I agree with Barry that low interest rates were a major cause of the housing crisis, if I were to go back and run the Fed from 2001-2006, rather than running a tighter monetary policy I would have kept the rate path unchanged, and instead I would have regulated mortgage originations far more aggressively. In fact, I would probably tap Scott Sumner to redesign how the Fed conducts monetary policy, so that NGDP expectations rather than short term interest rates are targeted. More here:
http://www.themoneyillusion.com/
Data here:
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http://data.bls.gov/PDQ/servlet/SurveyOutputServlet?data_tool=latest_num...
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