Monday, December 6, 2010

Why The Low Interest Rates Mattered: Part II

This is the second of two posts detailing why the Fed's low interest rate policies in the early-to-mid 2000s was one of the more important contributors to the credit and housing boom.  In the first post I discussed how the low federal funds rate acted as a catalyst in bringing together the other contributors--financial innovation, weak governance, misaligned incentives, and globalization--to create the perfect economic storm.  Here I want to (1) flesh out why the low federal funds rate mattered from a neutral interest rate perspective and (2) discuss how the Fed's low interest rate policy created a global liquidity glut. (The material in this post is mostly excerpted from a previous one of mine.)

(1) The Fed kept its policy interest rate, the federal funds rate, below the natural or neutral interest rate for an extended period.  It is not correct to say the Fed kept interest rates very low and thus monetary policy was very loose. Interest rates can be low because the economy is weak, not just because monetary policy is stimulative.  Interest rates only indicate a loosening of monetary policy if they are low relative to the neutral interest rate, the interest rate level consistent with a closed output gap ( i.e. the economy operating at its full potential).  There is ample evidence that the Fed during the 2002-2004 period pushed the federal funds rate well below the neutral interest rate level. For example, see Laubach and Williams (2003) or this ECB study (2007).  Below is graph that shows the Laubach and Williams natural interest rate minus the real federal funds rate. This spread provides a measure on the stance of monetary policy--the larger it is the looser is monetary policy and vice versa.  This figure shows that monetary policy was unusually accommodative during the 2002-2004 period. This figure also indicates an important development behind the large gap was that the productivity boom at that time kept the neutral interested elevated even as the Fed held down the real federal funds rate (click on figure to enlarge):

In short, during the early-to-mid 2000s the real federal funds rate was being pushed to an unusually low level just as the neutral real federal funds rate was rising because of the productivity boom.   Thus, monetary policy was highly stimulative.

A natural follow-up question is that if the federal funds rate was below the neutral rate for so long, then why was there strong disinflation during this time? The answer is that the same productivity boom that kept the neutral interest rate elevated also created deflationary pressures. The Fed saw the disinflation and acted as if it were created by weak aggregate demand (AD). Instead, it was strong aggregate supply (i.e. the productivity gains) creating the disinflation at the time. AD, in fact, was not falling during this time and could not have been the source of the low inflation. The figure below illustrates this point.  It shows the productivity surges at this time coincided with the two sustained drops in inflation.  Demand growth, meanwhile, is solidly recovering (click on figure to enlarge):

(2) Given the Fed's monetary superpower status, its loose monetary policy got exported across the globe. As a result, the Fed helped create a global liquidity glut that in turn helped fuel a global housing boom.  The Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy was exported to much of the emerging world at this time. This means that the other two monetary powers, the ECB and Japan, had to be mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's loose monetary policy also got exported to some degree to Japan and the Euro area.  From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s.  Inevitably, some of this global liquidity glut got recycled back into the U.S. economy and further fueled the housing boom (i.e. the dollar block countries had to buy up more dollars as the Fed loosened policy and these funds got recycled via Treasury purchases back to the U.S. economy). Below is a picture from Sebastian Becker of Deutsche Bank that highlights this surge in global liquidity:

Given these points and those noted in the previous post, I am convinced that the Fed probably  was one of the more important contributors to the credit and housing boom. If nothing else, it was the one institution that could have slowed down the housing boom through better oversight of lending practices and less monetary stimulus.   


  1. Thanks for these posts. You said in a comment on the previous point that
    "(The central bank) should avoid pushing the policy interest rate away from natural rate."

    If the central bank is pursuing your preferred NGDP growth target, so that there is no policy interest rate, does any of the analysis in this post still apply? How much do interest rates still matter to Fed observers/policymakers pursuing that type of policy? Is there any role at all?

    Your graph shows that NGDP growth rate was well above 5% from '03-'06, and it appears they began raising the fed funds rate as a consequence (Sumner's point). Yet immediately afterwards you argue that monetary policy became too loose.

    It's hard for me to see monetary policy through both lenses-- it appears we need to choose one (NGDP growth) or the other (pursuing the neutral real interest rate) for consistent analyses.

    Perhaps it would help if I looked at other historical departures of the ex post real rate and the neutral rate and hypothesize on their consequences? But I'm afraid I'd end up making the same case as Sumner by switching the lense-- NGDP growth was high in other periods and that didn't lead to a devastating bubble burst. And then I have to start looking at the other possible factors-- freer international capital flows and securitization after the 1970s, for example. And the more I start to do that, the less of a role it appears the Fed has.

    The Fed's role mattered, but in the absence of all the other factors it probably couldn't have mattered very much. (Hope that makes sense)

  2. JDTapp:

    Departures of the actual interest rate from the neutral interest rate imply departures of aggregate demand from a stable trend. The two are simply different manifestations of the same problem. They are by definition consistent. I think the difference between Scott and me is how we draw the stable trend, a measurement issue not a theoretical one.

    Bill Woolsey sums up nicely in this quote the point that deviations of interest rates from the natural rate level is the same as deviations of aggregate demand from its stable trend value. Here, Bill discusses it in the context of deficient aggregate demand:

    "Deficient aggregate demand--aggregate demand less than productive capacity = excess demand for money--a quantity of money less than the demand to hold money = a market interest rate greater than the natural interest rate--saving greater than investment.

    How do you know that aggregate demand is deficient? If cash expenditures have fallen below their trend growth path, and the levels of prices and wages have not fallen in proportion, then the presumption should be that aggregate demand is too low, that there is an excess demand for money, and that the market interest rate is above the natural interest rate.

    Never, never, never look at market interest rates and the quantity of money and compare them with historically "normal" levels."

  3. Thanks for the clarification and the Woolsey quote.

  4. Yes! Low interest rates and terrible lending practices by big banks allowed a great portion of the population to extend themselves well beyond their means. Despite this, practices such as Government subsidies of mortgages and tax incentives for homeowners (which is counter-intuitive) continue in the face of the crisis. I know that these incentives will help get us out of the mortgage crisis in the short term but ultimately, they need to be gotten rid of in the medium-to-long term.