Consensus Building That the Fed's Policies Were Too Tight
It’s certainly true that the Fed dropped its target federal funds rate in 2008. In fact, the Fed started steadily cutting its target in September 2007. In that month, it cut the target from 5.25 percent to 4.75. By the end of 2008, the target had been slashed to 1 percent.
But those cuts don’t mean the Fed’s policies could not have been too tight. Nominal interest rates are not always an accurate indicator of whether monetary policy is too loose or tight.
Remember, interest rates aren’t set by the Fed, they’re merely influenced by its policies. And even short-term rates—those most directly impacted by the Fed—still move according to the supply and demand of credit.
History shows that low interest rates do not necessarily reflect easy monetary policy. As Scott Sumner reminds us, “Friedman and Schwartz noted that in the 1930s the low interest rates and high levels of liquidity (cash and reserves hoarding) lulled people into thinking money was easy.”
Similarly, Milton Friedman observed:
"After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die."
Friedman’s point should not be very controversial among economists. But there remains some disagreement over what are, in fact, the best indicators for determining whether policy is too tight or too loose.
Some prefer to look at the monetary base (currency plus reserves), though history suggests the base, similar to interest rates, is not always the most accurate descriptor of the Fed’s policy stance.
Others focus on one of the broader monetary aggregates, like M1 or M2. Some research argues that a Divisia monetary index – something that measures the aggregate flow of monetary services – is a superior way to gauge monetary policy.
Preference for the Divisia seems counterintuitive, though, because it suggests the best way to measure whether policies have created too much money is not to simply count up all the money. Instead, the Divisia puts more emphasis on money used for transactions and less weight on money used for items such as long-term savings.
Others believe some measure of nominal spending, such as nominal gross domestic product (NGDP) or total final sales, is the best way to gauge whether policy is too tight. This theory basically holds that the Fed should do whatever is necessary to make sure nominal spending doesn’t collapse.
Those holding the NGDP view say the Fed should not pay attention to either interest rate or inflation targets. By focusing on maintaining growth in nominal spending, they argue, the Fed would implicitly be paying attention to inflation and employment.
But the Fed failed to maintain nominal spending in 2008.
The NGDP growth rate started a downward trend in the last half of 2007 and turned negative in the first quarter of 2008. Similarly, growth in final sales of domestic product slowed dramatically at the beginning of 2008, finally turning negative at the end of the year.
By either measure, monetary policy was too tight at some point in 2008. These are not, however, the only reasons to believe monetary policy was too tight leading up to the crisis.
Even though there was no dramatic decline in the monetary base from 2005 through August 2008, the monthly rate of growth was below the long-term average in 34 out of 44 months. And the rate turned negative in almost half of these months. Similarly, the rate of growth in the St. Louis Fed’s M1 Divisia index was below average in 38 of 44 months.
Even for those who insist on clinging to the interest rate fallacy, there’s a problem: the Fed started raising its target rate in the middle of 2004, and never lowered it again until September 2007. Over that period, the fed funds target rose from 1 percent all the way to 5.25 percent.
This trend may well indicate the Fed held its target too high for too long. Regardless, the economy collapsed on the Fed’s watch, and preventing economic collapse is the reason Washington created the Fed in the first place.
- Norbert J. Michel is a research fellow specializing in financial regulation for The Heritage Foundation’s Thomas A. Roe Institute for Economic Policy Studies.
Originally appeared in Forbes