John Taylor: The Fed Done It
By Arnold Kling
He is a leading macroeconomist, and he is out with a serious paper, in which he blames the Fed for excessively low interest rates from 2002-2004. Pointer from James Hamilton, who does not agree. Hamilton writes,
I feel he overstates the role of the Fed in directly causing all the problems. I would instead point to inadequate regulation of key financial institutions as the single most important factor…The Fed tried too hard to fight the jobless recovery of 2002-2004 with monetary stimulus, and that ended up making the severity of the subsequent downturn in housing that much worse.
I agree with Jim that the blame placed on the Fed is a bit simplistic.Taylor writes,
There was no greater or more persistent deviation of actual Fed policy since the turbulent days of the 1970s.
He is measuring monetary policy relative to the “Taylor rule” for GDP and inflation. However, as I have pointed out a number of times (most recently in my 65h lecture on macroeconomics), the period from 2002-2006 was very unusual in that productivity growth was quite rapid. As a result, GDP was high relative to employment. My guess is that if one were to estimate a “Taylor rule” using employment and inflation, monetary policy was not that unusual. In simple terms, we had a jobless recovery with low inflation, and it made sense for the Fed to follow an easy-money policy.
Taylor scores a point here:
within Europe the deviations from the Taylor rule vary in size because inflation and output data vary from country to country. The country with the largest deviation from the rule was Spain, and it had the biggest housing boom, measured by the change in housing investment as a share of GDP. The country with the smallest deviation was Austria; it had the smallest change in housing investment as a share of GDP.
He talks about the rise in interest rates for inter-bank borrowing.
market turmoil in the interbank market was not a liquidity problem of the kind that could be alleviated simply by central bank liquidity tools. Rather it was inherently a counterparty risk issue, which linked back to the underlying cause of the financial crisis. This was not a situation like the Great Depression where just printing money or providing liquidity was the solution; rather it was due to fundamental problems in the financial sector relating to risk.
…it certainly appears that the increased spreads in the money markets were seen by the authorities as liquidity problems rather than risk. Accordingly, their early interventions focused mainly on policies other than those which would deal with the fundamental sources of the heightened risk.
Taylor argues that consequently policy responses from late 2007 through the early summer of 2008 were ineffective. These included the Fed’s Term Auction Facility to expand bank reserves and its easing of the Fed Funds rate.
He goes on,
on Tuesday September 23, Federal Reserve Board Chairman Ben Bernanke and Treasury Secretary Henry Paulson testified at the Senate Banking Committee about the TARP, saying that it would be $700 billion in size. They provided a 2-1/2 page draft of legislation with no mention of oversight and few restrictions on the use. They were questioned intensely in this testimony and the reaction was quite negative, judging by the large volume of critical mail received by many members of the United States Congress. As shown in Figure 13 it was following this testimony that one really begins to see the crises deepening, as measured by the relentless upward movement in Libor-OIS spread for the next three weeks. Things steadily deteriorated and the spread went through the roof to 3.5 per cent.
His point is that Bernanke and Paulson created uncertainty, thereby exacerbating the counterparty risk. People simply did not know who was going to be rescued, or on what terms.