Tyler Cowen is wondering whether the Fed's low interest rates in the early-to-mid 2000s really were that important to the credit and housing boom of the early-to-mid 2000s. He is having is doubts after seeing this excerpt from Michael Woodford's JEP article:
It is popular to attribute the credit boom (at least in part) to the Federal Reserve having kept the federal funds rate “too low for too long,” but comparison of the path of the funds rate in Figure 5 with the measures of credit growth in Figure 1A shows that the increase in lending was greatest in 2006 and the first half of 2007, after the federal funds rate had already returned to a level consistent with normal benchmarks. Instead, the fact that spreads were unusually low precisely during the period of strongest growth in lending... indicates that an outward shiftof the supply of intermediation schedule XS was responsible.
A question to Tyler Cowen and Michale Woodford: aren't you just the least bit curious about the chronological ordering of the events in the above paragraph? First, the federal funds rate is held below the neutral interest rate level for an extended period. Second, spreads decline and a credit boom ensues. Hmm? Let see, that sounds a lot like the risk taking channel of monetary policy. Here is how Leonardo Gambacorta of the BIS summarizes this monetary transmission channel:
Monetary policy may influence banks’ perceptions of, and attitude towards, risk in at least two ways: (i) through a search for yield process, especially in the case of nominal return targets; and (ii) by means of the impact of interest rates on valuations, incomes and cash flows, which in turn can modify how banks measure risk.
In terms of the recent credit boom, this channel says that keeping short-term interest rate inordinately low was key in driving down credit spreads and spurring on the credit boom. In fact, Woodford's colleague at Princeton, Hyun Song Shin, and his coauthor Tobias Adrian have several papers on the risk taking channel. Here is an excerpt from a WSJ article from late last year that discusses how this channel was important to the recent credit boom-bust cycle: (My bold below)
Mr. Adrian and Mr. Shin find low rates feed dangerous credit booms, and thus need to be a factor in Fed interest-rate calculations. Small additional increases in rates in 2005, they say, might have tamed the last bubble. "Interest-rate policy is affecting funding conditions of financial institutions and their ability to take on leverage," says Mr. Adrian. That, in turn, "has real effects on the economy."
For a step-by-step account of how this channel worked during the credit boom see this post by Barry Ritholtz. Finally, let me end with George Selgin who provides an assessment of the above paragraph by Woodford:
Let's see: you have excessively low, even negative, rates for several years, and partly for this reason house prices rise exceedingly rapidly. That rapid appreciation in turn stimulates a greater demand for credit, so rates start to come up. At the peak of the lending boom, rates are at or near their "benchmark" levels again. Therefore low rates couldn't be to blame for the boom.
Wow. Now that I know the facts, I am really sorry to have been one of those naive economists who thought the Fed had something to do with it.