Mark Gertler: Don't Blame the Fed

Mark Gertler says that monetary policy from 2003 to 2005 helped to stabilize the economy and hence is not to blame for current problems in financial markets:

Bernanke Co-Author Says Fed Was NOT ‘Too Easy for Too Long’, WSJ Economics Blog: Mark Gertler, a prominent economist and close associate of Ben Bernanke, says the Fed didn’t create the current turmoil by keeping interest rates too low earlier this decade, as some have argued. Rather, Mr. Gertler, ... says investors and lenders became more comfortable with risk thanks to the greater stability of economic growth and inflation in recent decades. That “Great Moderation,” says Mr. Gertler, reflects better monetary policy. ...

For the second time in recent days The Wall Street Journal’s editorial page suggests that the recent turmoil in credit markets is due to “the Federal Reserve’s willingness to keep money too easy for too long” during 2003-2005. This kind of reasoning leaves me scratching my head: There is simply no hard evidence to support it. The only telltale sign of when a central bank has been too easy is rising inflation. While it is true that the ... personal consumption expenditures price index excluding food and energy, crept a bit above 2% for a period of time, this is hardly an indication of profligate monetary policy.

Understanding the recent financial market turbulence requires a more nuanced view: Since the early 1980s there has been a significant drop in the volatility of the macroeconomy. .... This phenomenon, known as the Great Moderation, is true not only for the U.S. economy but also for industrialized economies across the globe, with the notable exception of Japan. Most serious observers attribute the Great Moderation to three main factors: (i) good luck (smaller shocks); (ii) structural change (e.g. financial market innovations that have improved borrowing capacity); and (iii) improved monetary policy. While there is debate over the relevant importance of each factor, my own view is that each deserves about equal credit.

The decline in the aggregate volatility of the macroeconomy has naturally lead to a decline in both risk premia and credit spreads. This in itself should not be a problem. However, it is also possible that the relatively long period of tranquility ... has lead to a sense of complacency in financial markets, which in turn has lead investors to fail to appropriately discount risk and lenders to not apply standards that are sufficiently tight. It is also possible that there has been abuse of the existing regulatory system, particularly involving mortgage lending. These kinds of factors play out once the markets are put under stress and only serve to magnify the turmoil, as has been the case recently.

Now, about monetary policy during 2003-2005: By keeping interest rates low in the absence of inflationary pressures, the Fed prudently insured against a Japan-style stagnation. It is not unreasonable to suggest, further, that this period provides an illustration of how the Fed has contributed to the Great Moderation. So, oddly enough, Fed policy may be relevant to current financial market volatility not because it was bad, but rather because it was good!