The “too low for too long” hypothesis revisited

John Taylor writes:

In her  article “Alan Greenspan: What Went Wrong” in the Wall Street Journal Alexandra Wolfe considers whether monetary policy played a role in exacerbating the housing boom going into the financial crisis by holding interest rates “too low for too long.” I’ve argued that it did  (along with regulatory lapses) and wrote about it in a 2007 Jackson Hole paper.

Alan Greenspan disagrees with that paper, as Alexandra Wolfe reports, but she also reports that “Prof. Taylor stands by the paper in which he presented the idea. ‘The paper provided empirical evidence…that unusually low interest rates set by the Fed in 2003-2005 compared with policy decisions in the prior two decades exacerbated the housing boom,’ he wrote in an email. Other economists have corroborated the findings, he added, and ‘the results are quite robust.’”

I agree with Greenspan´s disagreement. The charts give a good visual of the process.

  1. House prices began to climb after mid-1997, all of six years before the so called “too low for too long” period.
  2. House prices took an almost imperceptible ‘breather’ during the 2001 recession and then resumed the upward trend at the same rate.
  3. They continued to climb after interest rates were increased starting in mid-2004

Too Low Too Long_1

Now, interest rates were not “too low” in 2002-04:

  1. Note that MP (monetary policy) was “easy” in 1998-99. That follows from the fact that NGDP was rising above trend, irrespective of the FF target rate being reduced (1998) or increased (1999)
  2. During 2001-03 MP was tight despite interest rates being reduced at an accelerated clip. Look at what was happening to NGDP.
  3. The introduction of “forward guidance” in August 2003 “loosened” monetary policy and NGDP started travelling back to trend.
  4. In 2007-08 MP was first ‘tight’ and then ‘exceedingly’ tight, despite the continued drop in the FF target rate.

Too Low Too Long_2

Bottom Line: Don´t look at interest rates to gauge the stance of monetary policy!

Update: Scott Sumner has a take

6 thoughts on “The “too low for too long” hypothesis revisited

  1. Pingback: TheMoneyIllusion » Greenspan vs. Taylor

  2. Marcus, do you think you are setting yourself, and us Market Monetarists in general, a tough test of Market Monetarism? If we are right in worrying about low and falling levels of NGDP in Euroland and elsewhere, what are the consequences? Is it just stubbornly high unemployment? I tend to think it is also the risk of a really poor response to an exogenous negative demand shock. What are you thinking?

    • James, stubbornly high unemployment has deep consequences. One of them is it brings forth very poor responses, especially from government. And then things start snowballing and risk getting even worse. We are seeing that sort of thing going on. So, in short, the dynamics that result from wrong MP have also long term consequences.

      • Thanks. It’s just that there seems to be quite a lot of optimism around, especially in stock markets, especially in EuroZone countries. It seems to run counter to the charts showing ever more “off course” NGDP growth. Maybe the exuberance is irrational, maybe we are in for some shocks. Interesting times, but still a test of MM for worrying about slow NGDP growth.

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