Does Williams Think the Fed Was Too Loose in the 2000s?
People are still debating who is to blame for the housing debt bubble. While there are many complementary explanations, the most heated arguments center on the role of monetary policy. Careful analysis suggests John Williams, the incoming president of the Federal Reserve Bank of New York, may agree with those who blame excessively low interest rates for the boom and bust. (Read more about his views here.)Remember what the world was like nearly two decades ago.
In response to the triple shocks of the tech bust, the Sept. 11 terrorist attacks, and the wave of corporate defaults in the early 2000s, Fed Chairman Alan Greenspan and the majority of his colleagues pushed the policy interest rate down to 1%. They believed low interest rates were necessary to offset the impact of lower stock prices. Business investment had collapsed, consumer prices were barely rising, and the job market was stagnant. The hope was that cheap credit could restore confidence and spur additional spending by households. If the dollar depreciated to the benefit of exporters, so much the better.
There were risks to this strategy, and these risks were known. Transcripts of Federal Open Market Committee meetings indicate concerns about house prices and home-equity extraction as early as 2001. Charles Kindleberger, the celebrated finance historian and author of Manias, Panics, and Crashes, spent the end of his life “cutting out newspaper clippings that hint at a bubble in the housing market, most notably on the West Coast,” according to a profile from July 2002.
Fed officials were also open about what they were doing, at least in FOMC meetings. The March 16, 2004, meeting was particularly noteworthy. Consider the following passage from Donald Kohn, then a member of the Board of Governors after having spent years as the Fed’s top bureaucrat:
Policy accommodation—and the expectation that it will persist—is distorting asset prices. Most of this distortion is deliberate and a desirable effect of the stance of policy. We have attempted to lower interest rates below long-term equilibrium rates and to boost asset prices in order to stimulate demand.…The macro imperatives are likely to outweigh any threat to financial or longer-term economic stability from accommodative policy. Many outsiders criticized the Fed for its policies at the time, most notably John Taylor of Stanford University and William White of the Bank for International Settlements. Their arguments were varied, but all agreed Kohn and Greenspan were understating the dangers posed to the financial system and overstating the real economy’s need for additional monetary juice.
John Williams, a career Fed economist who has recently been president of the San Francisco Fed and will soon be one of the most important monetary policy officials in the world when he moves to New York, has not commented much on this issue. He is, however, well-known for his research on the “natural rate” of interest, especially his view that the current level of the “natural” Fed policy rate is roughly 0% after subtracting inflation.
The model he developed with fellow Fed economist Thomas Laubach requires an estimate of “potential” economic output, which they define as the level of gross domestic product consistent with a stable consumer-price inflation rate. (Whether this definition is reasonable is a question for another day.) If GDP is rising above this theoretical bound, then policy by definition is too loose. If GDP is below the Laubach-Williams definition of potential output, then the Fed must be too tight.
By comparing actual GDP against their definition of potential over time and tracking those movements against the actual level of the federal-funds rate, Laubach and Williams can estimate the “natural” rate consistent with a policy stance that is just right.
Most people focus on their main result, which is the decline in the baseline interest rate*.
But the more interesting result is what you get from combining their estimates of the “output gap”—the difference between actual and potential GDP—and their estimates of the “natural rate” into an estimate for how the Fed should set rates. There are many ways to do this, but the standard one looks like this:
Optimal policy rate = natural real rate + inflation target + 1.5*(actual inflation – inflation target) + output gap
The chart below shows two versions of their implied “optimal policy rate,” based on whether you use the one-sided estimates or two-sided estimates. (All data are available here. The inflation target was set at 2%.) Both series were smoothed by taking four-quarter moving averages:
The chart should not be understood as an internally consistent counterfactual history but rather as a series of snapshots of what Fed policy should have been at given points in time if central bankers had possessed full knowledge of the future, according to Laubach and Williams.
For example, the model implies inflation would not have gotten out of control in the 1970s if the Fed had been much more aggressive at raising interest rates in the 1960s. That in turn would have obviated the need for the Volcker recession of the early 1980s and the low interest rates implied by the Laubach-Williams model if you start the clock in 1982.
None of this is particularly surprising. Most Fed officials would happily tell you the central bank was too loose in the first decade of the Great Inflation.
The surprising result of this extension of the Laubach-Williams model is what it says about Fed policy in the 2000s. Their implied policy rule suggests the Fed was several percentage points too loose, regardless of whether you use the one-sided or two-sided estimates as inputs. According to their two-sided estimate, which fully incorporates the benefits of hindsight, the Fed should not have lowered its policy rate below 3.5%—if that.
We explicitly asked the San Francisco Fed if this interpretation was fair or if Williams wanted to comment on our methodology. They said “we don’t have much to add.”
*The difference between the one-sided and two-sided estimates is that the one-sided estimates do not benefit from hindsight. The two-sided estimates are therefore “more accurate” for retrospectively evaluating policy and the economy but unrepresentative of what could have been known at the time.
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