In an oped today, Taylor writes :
It is a common view that the shutdown, the debt-limit debacle and the repeated failure to enact entitlement and pro-growth tax reform reflect increased political polarization. I believe this gets the causality backward. Today’s governance failures are closely connected to economic policy changes, particularly those growing out of the 2008 financial crisis.
The crisis did not reflect some inherent defect of the market system that needed to be corrected, as many Americans have been led to believe. Rather it grew out of faulty government policies.
In the years leading up to the panic, mainly 2003-05, the Federal Reserve held interest rates excessively low compared with the monetary policy strategy of the 1980s and ’90s—a monetary strategy that had kept recessions mild. The Fed’s interest-rate policies exacerbated the housing boom and thus the ensuing bust. More generally, extremely low interest rates led individual and institutional investors to search for yield and to engage in excessive risk taking, as Geert Bekaert of Columbia University and his colleagues showed in a study published by the European Central Bank in July.
Meanwhile, regulators who were supposed to supervise large financial institutions, including Fannie Mae and Freddie Mac, allowed large deviations from existing safety and soundness rules. In particular, regulators permitted high leverage ratios and investments in risky, mortgage-backed securities that also fed the housing boom.
I fully agree with the “regulators at fault” argument, but not at all with “the Fed´s interest rate policy exacerbated the housing boom and ensuing bust” argument.
The charts show a version of the “Taylor Rule”, the NGDP gap (the distance of NGDP from trend) and the path of NGDP and its trend.
Taylor subscribes to the conventional view that monetary policy equals interest rate policy. Therefore, if the FF rate is below the rate indicated by the “rule”, monetary policy is deemed “easy” (loose, lax), and vice-versa if the policy rate is above the “rule” rate.
But if you interpret “easy” monetary policy as NGDP growing above trend (positive gap) and “tight” monetary policy as NGDP growing below trend (negative gap) you would say that monetary policy was “too tight” in 2001-03 when the gap turned significantly negative (despite the policy rate being less than the rule rate)and that monetary policy was “correct” in 2003-05 when NGDP was converging to the trend level (closing the gap), despite the rising policy rate during part of this period.
When Bernanke took the Fed´s helm the gap had been closed. What happened going forward, in particular the complete loss of nominal stability in 2008, which made the financial crisis immensely more severe, is the doing of the Bernanke Fed. And this was motivated by a fixation on inflation, disregarding the NGDP level targeting rule that the Fed should not react to a supply (oil price) shock!