This is the view of John Taylor who weighed-in on the “Macro Models/New Keynesian Models” debate:
There’s a good debate going on about the usefulness of macro models, and in particular whether the so-called New Keynesian models let us down or even helped bring on the financial crisis and the Great Recession.
This weekend Noah Smith argues that the new Keynesian models were built for the “last war” and thus missed macro-financial connections or the zero interest rate bound needed to understand the Great Recession and slow recovery. Simon Wren-Lewis writes that the models omitted key factors by focusing too much on rational expectations and other micro-foundations which “crippled the ability of New Keynesians to understand subsequent real world events.” And back last summer Paul Krugman in Macroeconomists at War wondered if these models were being used much at all, saying “It would be interesting to know how many graduate departments were in fact teaching New Keynesian macro in 2008. My guess is that a fair number weren’t.” Underling the debate is an implicit view that New Keynesian models deserve much of the blame for the poor economic performance in recent years, and should be “taken to the woodshed” as Chris House put it.
I do not see the evidence that these models led policy makers astray or were a cause of the financial crisis. To the contrary I have argued that the general policy recommendations of these models—which generally took the form of particular monetary policy rules for the interest rate instrument—were not followed by policy makers in the years leading up to the crisis though they followed them during the Great Moderation. Ignoring the recommendations was the problem rather than the recommendations themselves. These models did not fail in their recommendations. Rather the policymakers failed to follow the recommendations.
That is just another way of saying that rates “too low for too long” were the cause of the house price boom and bust which morphed into the financial crisis giving rise to the “Great Recession”.
And as has become standard, the Fed avoided a second “Great Depression “ by, in the words of none other than Robert Lucas, “acting boldly as lender of last resort, just as it should have done in 1930s, but failed to do so”.
The chart below reproduces a chart in Taylor´s linked piece. He argues (through simulations) that by disrespecting the rule, the Fed caused havoc!
The next chart indicates that house prices had been going up since 1997 irrespective of what interest rates were.
A simpler version of the “rule”, devised by Mankiw, (which considers only core inflation and unemployment completely disregarding “natural rates” and “targets”) mimics Taylor´s counterfactual pretty well.
So, no matter your approach, rates were “too low for “too long”.
But note that the economy was not reacting to the persistent drop in rates that began in early 2001. In effect the chart below is a great example of the dictum: “low rates reflect the fact that monetary policy had been tight and high rates that it had been loose”. We see that low (falling) rates are associated with a negative (increasing) NGDP gap and high (rising) rates with a positive (shrinking) NGDP gap.
When did things began to change? When the Fed introduced forward guidance at the August 2003 FOMC meeting. The NGDP gap closes and, as the next chart shows, unemployment begins to fall (being the “mirror image” of the spending gap).
What was happening to inflation at the time? As the next set of charts show, headline inflation was “dancing to the beat of the oil and commodity price drums”, while core inflation remained pretty tame (although more often than not on the low side of 2%) all along.
As Scott Sumner said recently:
We should welcome an “abrupt policy adjustment.” It’s much better to get to full employment in one year and then abruptly adjust policy to keep NGDP rising along a 4.5% trend line, than it is to have a gradual recovery that asymptotically approaches full employment over many years. Which has been the actual policy since 2009, in case anyone didn’t notice.
In 2003, when the Fed decided to amend a situation that was infinitely more benign than the present one, it did so forcefully. But, despite the drop in unemployment and inflation (core) remaining very close to the “desired” level, to this day monetary policy is faulted!
One consequence of that misdiagnosis is that at present “expansionary monetary policy” (understood as actions that shrink the spending gap) is a taboo! Bubbles will inflate and a new crisis will ensue!
Update 2/22): While I was looking for the 2000s equivalent of Mussas´”Monetary Policy in the 1980s” and Mankiw´s “Monetary Policy in the 1990s”, I found this post by James Hamilton in 2011: “Monetary policy since 2000”.
This provides an interesting confirmation of the theme of a talk by Stanford Professor John Taylor also given at the conference. Taylor argued that a shift away from the policies followed in the 1990s was one factor contributing to the excessive housing boom and subsequent problems. My personal view is that Taylor overstates the contribution of low interest rates, and that poor regulation of the shadow banking system was a more important cause of the problem.
Nevertheless, I agree that the lax monetary policy of 2003-2005 was a mistake.
To which Mark Sadowski responds in the comments with his usual attention to details:
Li, Li and Yu estimate their model using an outcomes based Taylor Rule and the GDP deflator for the inflation rate. Poole (2007) estimated an outcomes based Taylor Rule using headline CPI and found that the Fed was unusually accomodative from about 2000 on. Orphanides and Wieland (2007) on the other hand estimated an expectations based Taylor Rule that used the the inflation measures that the Fed has actually been targeting and found no deviation during the 2000s.
The Fed switched from GDP deflator to headline CPI in 1988 and then to headline PCE in 2000 and finally core PCE in 2004. So the regime change that Li, Li and Yu are detecting in 2000 is most likely a combination of the fact that the Fed’s behavior seems better modeled by an expectations based Taylor Rule and that the Fed switched it’s measure of inflation in the 2000s.
On the question of whether policy was too accomodative one has too look at the results. If you believe that core inflation is a better measure of inflation inertia as I do then you’ll note that core PCE stayed within a narrow range of 1.5%-2.4% throughout 2000-2008. And GDP only went above potential in 2006-2007 and then only by a very modest amount. Similarly unemployment was below the natural rate only from March 2006 through November 2007 and never by more than 0.4 points.
So, no I don’t think Fed policy was excessively accomodative during the 2000s.
In the final analysis monetary policy should not have been held hostage to policing an asset bubble, even if it did contribute, which I sincerely doubt.