Saturday, May 8, 2010

Too Loose for Too Long...

I've read numerous times that the Fed Funds rate was kept "too low for too long" after the tech bubble burst. Academics, business people, pundits, and even some Fed officials have said this. And, in retrospect, that's to be expected. One can say, once the data is in, that mistakes were made. The question is, is the lesson we can learn from the mistake applicable to future circumstances?

The main issue here is, I think, whether Fed officials (the FOMC) can know when the Fed Funds rate is too low not in retrospect but in the moment. The "Taylor rule," of John Taylor, appears to be a guide. At least, one can know if the Fed Funds rate is low relative to what the Taylor rule would suggest. The problem isn't whether the Fed Funds rate is relatively low compared to the Taylor rule, though. The problem is whether the Fed Funds rate is relatively low (or high) compared to the interest rate set by the market. But that issue brings me to my next point, which is a parallel of the above.

The discussions around "too low for too long" remind me of discussions regarding the existence of an asset price bubble. First, bubbles are always claimed to have existed once the bubble has burst. A quick, but untestable, definition of a bubble is typically stated as unreasonably high asset prices. The question, of course, is what are the fundamentals that drive the price, and has the price become detached from its long-run relationship with the fundamentals? Speaking as a financial economist, bubbles are difficult to test for, and the methods used are numerous.

The parallel between the "too low for too long" and asset bubbles is this: easy to identify in hindsight, but very difficult to identify in the moment. The problem is that it is "in the moment" that is important. Many pundits and other writers have wondered why "we didn't see this coming." Of course, it is well known now that many economists and other people did see "this" coming. The issue was that policy makers were not listening to the nay-sayers. So the first problem is identification, and the second problem is convincing people that the current situation is untenable.

I think that we are again in a period where the Fed has manipulated the Fed Funds rate to a point that is too low, kept it there too long, and that stock prices and, yes, real estate prices are overly inflated. Greece is the harbinger of doom.

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