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John Taylor in the WSJ:
The Fed’s mistake of slowing money growth at the onset of the Great Depression is well-known. And from the mid-1960s through the ’70s, the Fed intervened with discretionary go-stop changes in money growth that led to frequent recessions, high unemployment, low economic growth, and high inflation.
In contrast, through much of the 1980s and ’90s and into the past decade the Fed ran a more predictable, rules-based policy with a clear price-stability goal. This eventually led to lower unemployment, lower interest rates, longer expansions, and stronger economic growth.
Unfortunately the Fed has returned to its discretionary, unpredictable ways, and the results are not good. Starting in 2003-05, it held interest rates too low for too long and thereby encouraged excessive risk-taking and the housing boom. It then overshot the needed increase in interest rates, which worsened the bust. Now, with inflation and the economy picking up, the Fed is again veering into “too low for too long” territory. Policy indicators suggest the need for higher interest rates, while the Fed signals a zero rate through 2014.
Wait, the Fed had a role in causing the financial crisis? I thought it was all Wall Street’s fault. As it so happens, there is a study out today that draws a similar conclusion:
Our analysis has shown that interest rates that are set too low for too long have a significant impact on the creation of housing bubbles. The strong link between deviations of short-term rates from Taylor-implied rates and housing bubbles suggest that in order to lean against house price fluctuations, it is not necessary to consider house prices directly in monetary policy decisions if policymakers set interest rates at levels close to those implied by the Taylor rule.
Our results highlight the additional complexity of maintaining an appropriate policy interest rate for a group of countries like the Eurozone that experience substantial heterogeneity in both the real estate markets as well as in the real economy. As we have seen, Taylor-implied rates as well as the development of house prices differ substantially between some Eurozone countries. Since it is not possible to react to this with a single monetary policy, country-specific measures should be taken to compensate for too low interest rates and in order to avoid a build-up of housing bubbles. This compensation could be achieved, for example, by introducing macroprudential instruments like countercyclical capital requirements for banks, limits for loan-to-income and loan-to-value ratios, or a countercyclical tax treatment of real estate holdings.
Then earlier this month, there was this research, which also put the blame for the financial crisis on easy credit rather than income inequality:
The negative and significant relationship of short-term interest rates and credit growth may also be consistent with the story of for example Taylor (2009) or Meltzer (2010) who attribute the U.S. housing boom to expansionary policy by the Federal Reserve in the early 2000s in an attempt to prevent perceived deflation. Moreover, housing booms and busts in other countries did not reflect redistributive housing policy. In the period before the Great Moderation they occurred during episodes of expansionary monetary policy … it now seems fairly clear from our examination of the data that neither have much to do with rising income inequality.
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