The consensus view is that monetary policy in the 2002 – 2006 period was lax, being at least partly responsible for “setting-off” the financial crisis and the “Great Recession”. I have long argued that´s not the case. In chapter 5 of my book with Benjamin Cole we analyze the period in detail. We write:
An analysis of the 2001 to 2006 period is important because many economists blame the Great Recession that began after mid-2008 on a credit boom instigated by the Fed in the years 2002-2005.
And therein is the irony: By the numbers, the Federal Reserve Board applied reasonable monetary policy in the years following June 2003, as indicated by the charts above. Yet the Fed has been widely dubbed as being “too easy” in this period.
It appears, contrary to the views of many, that central banking isn´t really about interest rates. After all, in 2001-03 rates had been brought to the ground, but not much had happened. They were raised after that, when the Fed was criticized as “too easy.” Moreover, Volcker is lionized as an inflation fighter (inflation down to 4%-5% in his era), while Greenspan is “too easy” (inflation often around 2% in his time).
In this post, Lars Christensen links to a new paper by John Taylor and to a related paper by Pelin Ilbas, Øistein Røisland and Tommy Sveen on “The Influence of the Taylor rule on US monetary policy”. The abstract reads:
“We analyze the influence of the Taylor rule on US monetary policy by estimating the policy preferences of the Fed within a DSGE framework. The policy preferences are represented by a standard loss function, extended with a term that represents the degree of reluctance to letting the interest rate deviate from the Taylor rule. The empirical support for the presence of a Taylor rule term in the policy preferences is strong and robust to alternative specifications of the loss function. Analyzing the Fed’s monetary policy in the period 2001-2006, we find no support for a decreased weight on the Taylor rule, contrary to what has been argued in the literature. The large deviations from the Taylor rule in this period are due to large, negative demand-side shocks, and represent optimal deviations for a given weight on the Taylor rule.”
And Lars writes:
John Taylor has long argued that the present crisis was a result of the Federal Reserve diverging from the Taylor rule in years just prior to 2008 and that caused a boom-bust in the UK economy. The aforementioned paper by Pelin Ilbas, Øistein Røisland and Tommy Sveen indicate that John Taylor is wrong on that view.
So concluding, John Taylor is right that we need a rule based monetary policy framework, but he is wrong about what rule we need.
HT Jens Pedersen
PS I still find Taylor’s focus on interest rates as a monetary policy instrument both frustrating and very wrong. It might have been the biggest problem with the Taylor rule – that central bankers have been led to think that “the” interest rate is the only instrument at their disposal.
I feel both “formally vindicated” and happy not having to do a “thought overhaul”.