A straightforward, long-valued policy benchmark called the Taylor Rule might have led the Fed to raise interest rates in 2002-2005 — had they not talked themselves out of following it. For many observers who believe that the run-up in housing prices was largely caused by artificially low interest rates, standing by the Taylor Rule might have been enough to prevent the meltdown altogether.
The Taylor Rule calls for central banks (like the Fed) to raise interest rates in response to trigger levels of inflation (and lower them in response to a recession). In an opinion piece in today’s Wall Street Journal, Professor John B. Taylor of Stanford (creator of the Taylor Rule), offers his view on the Fed’s surprising deviation from the Rule, which has been credited with contributing significantly to more than two decades of market stability from the late 70s to the beginning of the current century.
In a nutshell, the Fed relied on their own calculation of inflation risk — instead of actual, calculated inflation during the period. Were Greenspan, Bernanke, et al rationalizing to keep interest rates low — perhaps for political reasons? As Taylor notes, there were many other indicators that money was too cheap and inflation was underestimated — including observations from leaders of several state Federal Reserve Banks that interest rates were in fact negative over a large portion of 2000-2010. Interest rates below zero in effect subsidize borrowers — an indisputable contributor to “irrational exuberance” in real estate markets.
To read Taylor’s entire contribution, click here.