When the Fed Does Too Much

Course Outline

When the Fed Does Too Much

If you think through all of the variables that shape a country’s economy, it’s no wonder that monetary policy is difficult. It should also come as no surprise that the Federal Reserve doesn’t always get it right. In fact, sometimes the Fed’s actions have made the economy worse off.

Prior to the Great Recession, and in response to the recession of 2001, the Fed took steps to stimulate aggregate demand. It kept interest rates low, which meant that credit was cheap – including credit for stuff like mortgages.

Cheap credit has the potential to fuel asset bubbles. For example, in the early to mid 2000s, housing prices were increasing year over year. Both buyers and lenders became overconfident. And, while it’s easy for us to see what happened in hindsight, very few people spotted the trouble ahead.

This is an example of where action was the problem. But what about inaction? Most economists agree that the Fed’s choice to not increase the money supply in the 1930s actually made the Great Depression worse.

If the Fed could have foreseen the housing crisis, what could they have done to prevent it? What are some different viewpoints on the role of the Fed? We’ll cover these in detail in the video (and the quantity theory of money will make a reappearance!).

Teacher Resources

Transcript

The economy is complex, and it operates according to uncertain rules. This makes monetary policy difficult and sometimes the Fed's actions have made things worse rather than better. Let's take a look at the Great Recession. In an earlier video, we showed how increased leverage, mortgage securitization, and overconfidence contributed to the Great Recession. In this video, we're going to take a look at how the Fed's actions before the recession -- how they might have promoted the housing bubble, making the eventual recession worse.

 

In the late 1990s, the American economy was booming, with low unemployment and low inflation. The recession in 2001 appeared to be mild, but it was troubling that the unemployment rate remained high even after the recession officially ended. In an effort perhaps to bring back the 1990s, and to reduce unemployment, the Fed continued to try to increase aggregate demand, even after the recession had ended. In particular, the Fed kept the federal funds rate very low. A low federal funds rate makes credit cheaper and cheap credit can fuel an asset bubble. A bubble is when asset prices rise far higher and faster than can be explained by the fundamentals.

 

 

Irrational exuberance, rather than analysis, begins to drive prices higher and higher and higher. By keeping interest rates low, the Fed's policy in the early to mid-2000s encouraged people to buy more homes. Housing construction increased and that did generate lots of jobs. But as housing prices increased, year after year after year, it also made buyers and lenders overconfident. The Fed kept the federal funds rate very low until mid-2005. Housing prices peaked in 2006, shortly after the rate began to increase. And housing prices started to crash in 2007.

 

 

When housing prices started to fall, homeowners felt poor and they spent less. Home construction slowed down and halted. Aggregate demand fell. The Fed probably did keep interest rates too low for too long, but they also underestimated the effects that a decline in the housing sector would have on the overall economy. In fact, few people at the time understood how large the shadow banking system was, or how tied it was to the housing sector through mortgage-backed securities.

 

 

We should also recognize that bubbles -- they're much easier to see in hindsight than they are in real time. Every bubble comes with a story about why this time is different. The trouble is, sometimes the times -- they really are different. Even if the Fed knew that housing prices were too high, and even if they had wanted to restrain prices, the Fed has limited tools. Monetary policy -- it's simply a crude way to pop a bubble. Monetary policy can influence aggregate demand, but by reducing aggregate demand, the Fed is slowing down the entire economy, not just the housing sector. That's not a very efficient way to manage an asset price bubble.

 

 

Now the Fed does have the power to regulate banks, and it could have used some of that power to restrain some of the abuses in subprime mortgage lending. That would have been a more targeted attack on the sector that was overheating. So, the Fed's actions may have contributed to the housing bubble and the Great Recession, but failing to act can also have disastrous consequences. For example, most economists agree that the Fed's inaction during the 1930s -- they made the Great Depression much worse.

 

 

During that time, the U.S. money supply fell by about a third -- the largest drop in aggregate demand in American history. And the Fed mostly watched from the sidelines, when instead very strong actions to increase the money supply were called for. Rather than hoping that wise policymakers will make the right decision at just the right time, some economists argue that the Fed should follow a rule rather than relying on discretion. Milton Friedman, for example, suggested a money supply rule, a rule that would have M1 or M2 grow at a constant rate -- say 3% a year -- to match the growth rate of real GDP.

 

 

Money supply rules work best when velocity is constant. But when there are large shocks to the economy, such as the Great Depression and the Great Recession, velocity usually falls. So, these rules can mislead, just when you need them most. To avoid some of the pitfalls of a strict money supply rule, other economists have suggested targeting inflation, or nominal GDP. A nominal GDP rule, for example, would keep nominal GDP -- M times V -- growing at a constant rate. If the Fed had followed a nominal GDP rule, for example, then the recession of 2008 -- it might have been much milder.

 

 

But it's not clear that it could have followed the rule. Beginning in late 2008, the Fed doubled the monetary base in just four months -- the largest increase in history. But keeping nominal GDP growing would have required injecting even more money into the economy. It's not clear that the Fed could have done that, as that kind of action is unprecedented in monetary history. And we don't really know how the economy, or the political system, how they would have responded to such unprecedented policies. The bottom line is this -- the Federal Reserve has some powerful tools at its command, so designing monetary institutions and rules is important if the Fed's power is to help more than to harm.

 

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