Federal Reserve Secrets?

If you could ask God one question, what would you ask?  In today's economic world, Central Bankers are demi-gods. Last Friday (May 1st), San Francisco Federal Reserve President John C. Williams gave a talk at Chapman University.

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John C. Williams
President, San Francisco Fed

As I walked to the event, I felt the effect of being close to power. There are ten members of the Federal Reserve Open Market Committee, and I was hoping to ask a question of one of those ten powerful people. Think of what you would ask in this situation before reading more. My question was: 

The Question: Did the Fed Cause the Financial Crisis?

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In the sections below, I will more fully describe the question, I explain the motivation for the question, and then I will report President Williams' answer. 

In my question for President Williams, I laid out (in a polite academic manner) the argument that the Fed played a significant role in creating the financial crises.

1. The Fed pumped up risky assets including housing prices by aggressively cutting interest rates. The Fed Funds rate was at 2% or lower for over two years between 2002 and 2004. During this period of Fed-created low interest rates, housing prices rose in an historic fashion. Adjusted for inflation, US home prices show two abnormal periods: Home prices went down in the Depression, and home prices rose rapidly before the financial crisis. (click for wikipedia graph of long-term U.S. housing prices). 

2. The Fed halted the housing market boom by rapidly ramping up interest rates. The Fed Funds rate rose from 1.0% in May of 2004 to 5.25% in August 2006. 

3. The rise and fall in housing prices caused myriad foreclosures of individual homeowners, the collapse of Lehman Brothers, and the government rescue of AIG, Fannie Mae, and beyond. 

Did U.S. Monetary policy cause the financial crisis by massive easing followed by rapid tightening. In short, did the Fed press the gas pedal to the floor then slam on the brakes? 

Did the Fed cause the financial crisis (2008-2009)?

a) The Fed was the primary cause of the financial crisis.
b) The Fed was an important cause of the financial crisis.
c) the Fed was a minor cause of the financial crisis.
d) The Fed was not a cause of the financial crisis.
e) Other.

What do you think? 

    Click to vote

Why focus on the Greenspan-Bernanke Fed of 2001-2007?

Why did I ask an historical question? Would it be better to have asked about current conditions?

My motivation is that I worry about parallels between the historical period and today. Specifically, I worry about the impact of extremely low interest rates on risk-taking. 

In 2002-2004 the Fed kept interest rates very low in the context of a moderate unemployment rate. 

Today, the Fed is pursuing its Zero Interest Rate Policy (ZIRP). The current unemployment rate is 5.5%

ZIRP puts pressure on savers, especially on retired people. With hindsight, we know that people took all manner of crazy risks in the low interest rate period of 2002-2004. The consequence of those bad decisions became apparent only years later. My fear is that similar crazy decisions are being made today; risks with costs that will become apparent only in the future.

President Williams' answer

President Williams was polite while I asked my question. In the context of the survey question above, I interpret his answer as, "c) The Fed was a minor cause of the financial crisis." 

President Williams elaborated on this answer. 

First, he said that the Fed's contribution to the financial crisis lay more in a failure to regulate, than in a failure of monetary policy. For example, the Fed allowed Lehman to increase its risk-taking in the period before Lehman failed. (This is my illustration of President Williams point - he did not mention Lehman). (Click here for Wikipedia on Lehman risk-taking and bankruptcy.)

Second, President Williams singled out the rapid raising of interest rates beginning in 2004. To the extent that Fed monetary policy before the Financial Crisis was not perfect, the flaw lay in the rapid rate increases, not in the very low rates between 2002 and 2004. 

President Williams' answer is consistent with his talk from last week (click for .pdf). The Fed has been under tremendous pressure to adopt a more mechanical, less discretionary monetary policy. 

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Stanford Professor John Taylor is the leading academic proponent of a rules-based Fed. (Click here for an academic version of Professor Taylor's argument, Click here for a lay summary by Professor Taylor). 

President Williams' talk, "Monetary Policy and the Independence Dilemma," at Chapman can be viewed as a response to Professor Taylor's argument that a rule-based approach would be better. 

Returning to President Williams' answer, he said the main monetary mistake (he did not use the word mistake) made by the Fed was getting locked into raising rates by 25 basis points per meeting. In effect, he argued that the Fed should have used more discretion in raising rates. 

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President Williams' comments are thus consistent with the Fed's current statements. 

The Fed will raise rates when it is ready, and the Fed will use its discretion to decide on the pace of future rate increases. 

Note: President Williams was gracious, and he even gave me a t-shirt. 

President Williams' gift to author

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