John Taylor Thinks Low Interest Rates Contributed To The Credit Crisis

He wrote an article for the Wall Street Journal called The Fed and the Crisis: A Reply to Ben Bernanke (1-11-2010, p. A19). Low interest rates can mean too many people borrowing money to buy things like houses. Then too many are built and prices collapse, people can't pay their loans back and banks start to lose money. Ben Bernanke said that low interest rates were not the problem. But Taylor, an economics professor at Stanford had this to say to refute Bernanke:

"My critique, which I presented at the annual Jackson Hole conference for central bankers in the summer of 2007, is based on the simple observation that the Fed's target for the federal-funds interest rate was well below what the Taylor rule would call for in 2002-2005. By this measure the interest rate was too low for too long, reducing borrowing costs and accelerating the housing boom. The deviation from the Taylor rule, which had characterized good monetary policy during the previous two decades, was the largest since the turbulent 1970s."

"he put the Fed's forecasts of future inflation into the Taylor rule rather than actual measured inflation."

"First, the Fed's forecasts of inflation were too low. Inflation increased rather than decreased in 2002-2005."

"if one uses the average of private sector inflation forecasts rather than the Fed's forecasts, the interest rate would still have been judged as too low for too long."

"Mr. Bernanke cites no empirical evidence that his alternative to the Taylor rule improves central-bank performance."

"Mr. Bernanke also said that international evidence does not show a statistically significant relationship between policy deviations from the Taylor rule and housing booms. But his speech does not mention that research at the Organization for Economic Cooperation and Development in March 2008 did find a statistically significant relationship."

"two of the economists he cites—Frank Smets, director of research at the European Central Bank, and his colleague Marek Jarocinski—reported in the July/August issue of the St. Louis Fed Review that "evidence that monetary policy has significant effects on housing investment and house prices and that easy monetary policy designed to stave off perceived risks of deflation in 2002-04 has contributed to the boom in the housing market in 2004 and 2005.""

"The real interest rate during this period was persistently less than zero, thereby subsidizing borrowers."

" an objective observer of all this evidence would have to at least admit the possibility that monetary policy was too easy and a possible contributor to the crisis."

"Indeed, one of the lines from Mr. Bernanke's speech most picked up by Fed watchers is that "we must remain open to using monetary policy as a supplementary tool for addressing those risks." We have very limited ability to fine tune monetary policy in such an interventionist way."

"it is wishful thinking that some new and untried macro-prudential systemic risk regulation will prevent bubbles."