Last week, I reflected a little on how the Federal Reserve approached monetary policymaking five years ago, when labour markets were still quite loose but a housing bubble was beginning to inflate:
On the other hand, the Fed wasn't exactly standing pat during the growth of the housing bubble. From June of 2004 until June of 2006, the Fed steadily raised interest rates. Housing prices began falling around May of 2006. At the time of the rate increases output was posting some nice gains, but prices weren't rising by all that much. It's very interesting to think about how the period from 2006 until now might have been different if in 2004 and 2005 the Fed had taken a strong rhetorical and regulatory stance against the housing bubble but had kept rates at relatively low levels.
On the heels of this post, James Hamilton blogged about a new paper of his, co-authored with Seth Pruitt and Scott Borger. The researchers attempted to analyse market interest rate changes to determine what rules markets thought the Fed was following. Their findings:
We document two important changes in the perceived policy rule over time. After 2000, the market believed that the Fed would eventually have a stronger response to inflation than it had prior to 2000, but also that the Fed would take longer to implement those changes, responding to news more sluggishly than it had before 2000.
We study the consequences of these changes using a simple new-Keynesian model. We find that the first change (a stronger long-run response to inflation) would be something that would have made output less variable, whereas the second change (a smaller immediate response) would have made output more variable. According to these simulations, increased Fed inertia undid some of the benefits it could have otherwise obtained with its anti-inflation policies.
Our conclusion is that the measured pace at which Greenspan increased interest rates over 2004-2005 may have been counterproductive, and that economic performance might have been improved if the Fed instead had raised interest rates more quickly to the higher warranted levels.
The Fed began tightening in June of 2004 and continued steadily until June of 2006, never increasing rates more than 25 basis points at a time. This strategy may well have seemed prudent at the time, but in retrospect it appears to be among the worst possible polcy decisions—too tentative to shake the bubble mindset developing in housing, and least accommodative just as the bubble was running out of steam and the economy was heading for deep recession.
This article originally appeared on Economist.com