John Taylor presented a paper in September 2007 with the above title (without the Lessons Learned part). It concludes that probably the interest rate was set too low in the period after 9/11. The discussion can be followed at Econbrowser. Whatever the reasons were that lead to the housing bubble, how should the Fed now deal with it?
Taylor presents five points as Lessons Learned:
1) Adjust the short term interest rate according to macroeconomic developments in inflation and real GDP.
2) Provide all the funds that banks want to hold at the short end of the market at the current policy rate.
3) Publishing daily data in real-time would increase clarity and transparency.
4) Insisting on accountability for mortgage originators and improving the supervision of ‘off-balance’ sheet operations such as conduits.
5) The IMF adheres to its new Exceptional Access Framework which provides the same kind of predictability to its lending decisions as I am arguing has been and is essential for central bank decisions.
So far, I think that only points 1 and 2 have been touched. The regulatory framework was not overhauled (yet?), and also emerging economies are still doing fine. The Fed has injected liquidity into the market more than once when markets were in danger of drying up. Now that the Fed has started to lower the interest rate one could argue that this was done as a reaction to fears of a recession. So far, the Fed seems to be pretty much in line with Taylor’s 5 points (Points 3 and 4 need some time, so I wouldn’t argue that the Fed will not act).
My question now is: Can you just ignore the housing bubble? The Fed now acts as if it is in danger of a recession. You could however argue that the economy will need to go through a phase of contraction in order to clean up the financial sector. Otherwise, low interest rates will again fuel the housing bubble. The housing bubble can then only be maintained by low interest rates. The Fed could then try to slowly raise them in order to produce a soft landing. I doubt that this is possible though. Domestic consumption has been fueled by the housing bubble, and this means that future consumption has to be lower in order to make up for not saving enough/overspending. This means that aggregate demand declines, since growth in exports alone will not suffice to close the gap. The danger arises to end up in a situation like Japan in the 90s, with a financial sector holding bad loans and unwilling to lend while consumers are struggling to pay off old debt and holding on to their jobs, saving a lot because of the insecurity.
Joseph Stiglitz argues that this gloomy outlook can be combined with rising inflation to produce stagflation, the worst-case scenario of any economist:
Until now, three critical factors helped the world weather soaring oil prices. First, China, with its enormous productivity increases – based on resting on high levels of investment, including investments in education and technology – exported its deflation. Second, the US took advantage of this by lowering interest rates to unprecedented levels, inducing a housing bubble, with mortgages available to anyone not on a life-support system. Finally, workers all over the world took it on the chin, accepting lower real wages and a smaller share of GDP.
That game is up.
This is an interesting view, and for one thing the price of Chinese goods is increasing the U.S. inflation now (although Paul Krugman thinks that it does not matter much). And I think that somehow there is still a risk that the Chinese central bank will get rid of a serious amount of its dollar reserves, which are not necessary in an economic sense. Already China is spending some of the money by acquiring stakes in companies worldwide, like the recent $5 billion injection into Morgan Stanley by the China Investment Corporation. It seems only a matter of time until the dollars return home.
UPDATE 03/02/2008: Greg Ip at the WSJ has the story of rising inflation expectations.