A New York Times op-ed piece from earlier this week has reignited discussion about housing and the Federal Reserve as factors in the 2008-2009 Great Recession. Minds will differ on exactly how much of the financial crisis and economic contraction was triggered by the housing crisis. As for assigning blame to the Fed’s monetary policy, there’s a popular but misleading narrative that deserves attention: the central bank wasn’t culpable because it was cutting interest rates in late-2007 through 2008. True, but the Fed still deserves criticism based on other measures of monetary policy during that period—measures that arguably offer more insight for quantifying the central bank’s influence on the business cycle and for providing insight going forward for assessing macro risk.
In other words, the Fed funds target rate can be poor guide for evaluating monetary policy. A number of economists have made this point in recent years based on the hard data, including Bentley University’s Scott Sumner and Robert Hetzel at the Richmond Fed.
This week’s NY Times op-ed by David Beckworth and Ramesh Ponnuru draws on the growing body but often misunderstood body of research that persuasively argues that Fed did in fact keep policy too tight during 2007-2008. The numbers certainly look convincing when you look beyond the Fed funds rate. The bottom line: it’s reasonable to argue that Fed policy, once again, was a key factor in triggering the last recession. As Beckworth and Ponnuru explain:
Through acts and omissions, the Fed kept interest rates and expected interest rates higher than appropriate, depressing the economy. This point is easy to miss because the Fed lowered interest rates between September 2007 and April 2008. But raising rates is not the only route to tighter money.
Between late April and early October, the Fed kept the interest rate over which it has most direct control, the federal funds rate, at 2 percent. But when the economy weakens, the “natural†interest rate — the rate that keeps the economy on an even keel — falls. By staying in place, the Fed’s target interest rate was rising relative to that natural rate. The gap between expected interest rates and the natural rate was rising even more. Fed officials spent the late spring and summer of 2008 warning that rates would have to rise to combat inflation. Futures markets showed a sharp increase in expected interest rates.
