Wednesday, September 12, 2007

This is the mess that the Fed hath made....

.....let us rejoice and ask them to fix it??

One big reason why we are in the mess we are in today is that the Fed kept short term interest rates too low for too long compared to the benchmark that many policymakers pay homage to, namely the Taylor Rule.

The classic version of the Taylor Rule takes the inflation target to be 2%, the long term real interest rate to be 2% and calls for raising rates when inflation is above 2% and when output is above potential. From 2001 through 2005 the Taylor Rule called for an average Fed Funds rate of 4.92% (I used actual inflation not core inflation and measured potential output using the Hodrick Prescott filter to generate these numbers), while the actual rate averaged 2.9%. The graph below shows the quarter to quarter details.

So during Greenspan's last five years, the Fed Funds rate was on average two full percentage points below the benchmark, and the benchmark takes economic conditions into account!!!

Ironically, everyone is clamoring for the same organization to rescue them using the same tactic that helped to create the original problem: lowering rates.