Thursday, December 24, 2009

Was the U.S. monetary policy too loose during the housing boom?

John Taylor is an economics professor at Stanford University. In a 1993 paper, he introduced the Taylor rule, which provides guidance to central banks on how to determine short-term nominal interest rate (called the federal fund's rate in the US). It relates the interest rates to the amount of slack in the economy and the inflation rate.

He presented at the Fed's annual conference at Jackson Hole in 2007 evidence that suggested that the Fed's loose monetary policy in the 2000-2006 period was too loose. He then uses this data to argue that it was one of the biggest triggers of the housing boom in the US.

The Economist published an article, Fast and Loose, in Oct 2007 that illustrates the monetary excesses. Below is a chart from the article.

The dot-com bubble had burst and the economy was in recession. By 2003, Mr Greenspan, the chairman of the Fed then, had lowered the federal fund's rate to 1%, the lowest since 1958. He kept the interest rate at 1% for an entire year. He justified this decision by saying that he feared that America was on its way to deflation. As per Taylor's rule, the interest rate should have been above 3%. So, even though the Taylor rule is only a guide, Mr Greenspan had missed the mark by about a mile. Furthermore, Mr Greenspan said that interest rate would be low for "a considerable period" and that the Fed would rise it slowly at a "measured pace".

Gradually the Fed started raising the interest rates in quarter point steps. By June 2006, the interest rate was at 5.25%, as recommended by the Taylor's rule. So, looking back at the chart, US had over 4 years of loose monetary policy - enough time for an asset bubble to grow - all in the fear of deflation.

The housing bubble has burst. And coincidentally, Mr Bernanke, the current chairman of the Fed, just repeated Mr Greenspan's 2003 words - low interest rates for a "considerable period" and Fed will raise the interest rate slowly at a "measured pace". Would it be a coincidence that the current loose monetary policy is giving birth to yet another asset bubble?

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