Why the Low Interest Rates Mattered

by: David Beckworth
This is a follow up to my previous post, where I argued that the Fed's low interest rate policy was a key contributor to the credit and housing boom.
Part I
Here, I want to show why the risk-taking channel of monetary policy is an important part of the story. I will provide a more thorough summary of the Fed's role in the next post.
The risk-taking channel of monetary policy helps us understand how the Fed's low interest rate policy worked to catalyze many of the other factors that contributed to the housing boom. Yes, this was a perfect economic storm of sorts where financial innovation, weak governance, misaligned incentives, and globalization all came together to create the mother of all housing booms. Yet, the role they played was largely dependent on the Fed holding the federal funds rate as low as it did for as long as it did. How you ask? I will outsource to Barry Ritholtz to answer this question:

What Bernanake seems to be overlooking in his exoneration of ultra-low rates was the impact they had on the world’s Bond managers — especially pension funds, large trusts and foundations. Subsequently, there was an enormous cascading effect of 1% Fed Funds rate on the demand for higher yielding instruments, like securitized mortgages...
An honest assessment of the crisis’ causation and timeline would look something like the following: ...
It became readily clear to me once I dug into the data, legislative history, market activities, etc, that there was no one single factor that caused the collapse. Rather, an honest reading of events was that there were many, many failures occurring in a very specific order that contributed to what occurred.
Inadequate regulations and “nonfeasance” in enforcing existing regs were, as Chairman Bernanke asserts, a major factor. But in the crisis timeline, the regulatory and supervisory failures came about AFTER the 1% Fed rates had set off a mad scramble for yields. Had rates stayed within historical norms, the demand for higher yielding products would not have existed — at least not nearly as massively as it did with 1% rates.

Enough said.

Part II
Here I want to (1) flesh out why the low federal funds rate mattered from a neutral interest rate perspective and (2) discuss how the Fed's low interest rate policy created a global liquidity glut. (The material in this post is mostly excerpted from a previous one of mine.)

(1) The Fed kept its policy interest rate, the federal funds rate, below the natural or neutral interest rate for an extended period. It is not correct to say the Fed kept interest rates very low and thus monetary policy was very loose. Interest rates can be low because the economy is weak, not just because monetary policy is stimulative. Interest rates only indicate a loosening of monetary policy if they are low relative to the neutral interest rate (pdf), the interest rate level consistent with a closed output gap ( i.e. the economy operating at its full potential). There is ample evidence that the Fed during the 2002-2004 period pushed the federal funds rate well below the neutral interest rate level. For example, see Laubach and Williams (2003) (pdf) or this ECB study (2007) (pdf). Below is graph that shows the Laubach and Williams natural interest rate minus the real federal funds rate. This spread provides a measure on the stance of monetary policy--the larger it is the looser is monetary policy and vice versa. This figure shows that monetary policy was unusually accommodative during the 2002-2004 period. This figure also indicates an important development behind the large gap was that the productivity boom at that time kept the neutral interested elevated even as the Fed held down the real federal funds rate (click on figure to enlarge):

In short, during the early-to-mid 2000s the real federal funds rate was being pushed to an unusually low level just as the neutral real federal funds rate was rising because of the productivity boom. Thus, monetary policy was highly stimulative.

A natural follow-up question is that if the federal funds rate was below the neutral rate for so long, then why was there strong disinflation during this time? The answer is that the same productivity boom that kept the neutral interest rate elevated also created deflationary pressures. The Fed saw the disinflation and acted as if it were created by weak aggregate demand (AD). Instead, it was strong aggregate supply (i.e. the productivity gains) creating the disinflation at the time. AD, in fact, was not falling during this time and could not have been the source of the low inflation. The figure below illustrates this point. It shows the productivity surges at this time coincided with the two sustained drops in inflation. Demand growth, meanwhile, is solidly recovering (click on figure to enlarge):
(2) Given the Fed's monetary superpower status, its loose monetary policy got exported across the globe. As a result, the Fed helped create a global liquidity glut that in turn helped fuel a global housing boom. The Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy was exported to much of the emerging world at this time. This means that the other two monetary powers, the ECB and Japan, had to be mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's loose monetary policy also got exported to some degree to Japan and the Euro area. From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s. Inevitably, some of this global liquidity glut got recycled back into the U.S. economy and further fueled the housing boom (i.e. the dollar block countries had to buy up more dollars as the Fed loosened policy and these funds got recycled via Treasury purchases back to the U.S. economy). Below is a picture from Sebastian Becker (pdf) of Deutsche Bank that highlights this surge in global liquidity:

Given these points and those noted in the previous post, I am convinced that the Fed probably was one of the more important contributors to the credit and housing boom. If nothing else, it was the one institution that could have slowed down the housing boom through better oversight of lending practices and less monetary stimulus.