Kiel Institute Focus 8

Is Monetary Policy in the United States Too Expansionary?*

by Nils Jannsen and Joachim Scheide

The Federal Reserve (Fed) eased monetary policy massively as a response to the housing crisis and the financial crisis. From September 2007 onwards, the Fed lowered the federal funds rate from 5.25 percent to close to zero within one and a half years. Moreover, housing and financial markets were stabilized by numerous direct interventions (Quantitative Easing). Recently, the Fed announced it would purchase treasury bonds with a final volume of 600 billion Dollars by the middle of the year. However, with the recovery ongoing, it is becoming more and more questionable whether such an expansionary monetary policy is still appropriate or whether it increases the risks to price stability and that there may be exaggerations on other markets. The latter is a particularly important aspect, since there is some evidence that a too expansionary monetary policy contributed to the housing boom in the United States that finally triggered the financial crisis.

What Does the Taylor Rule Recommend?

Taylor rule is a standard instrument for evaluating monetary policy and can be interpreted as a reaction function of a central bank as well as a normative rule. It calculates the appropriate interest level based on current inflation or inflation expectations and the output gap. While the Taylor rule has in the meanwhile been applied in a multitude of specifications, the rule originally proposed by Taylor (1993),

has remained a useful tool for policy evaluation. In this rule, deviations from the inflation rate to the inflation target and from output to potential output are given a weight of 0.5. In the following, we set the inflation target (p*) equal to 2 and potential growth as a proxy for the steady state real interest rate (rr*) equal to 2.5. Because output gap estimates are known to be particularly uncertain, we use three alternative output gap estimates for our calculations, one from the Congressional Budget Office (CBO), one from the OECD, and one based on the Hodrick-Prescott Filter.^[1]

Figure 1 shows that monetary policy according to the Taylor rule is currently too expansionary, regardless of which output gap estimate is used. This is particularly true when we assume that at least some of the quantitative easing measures are expansionary too, so that monetary policy is currently even more expansionary than the federal funds rate indicates. Based on the output gap estimate of the CBO, the interest rate should be close to 0.5 and the federal funds rate is only slightly too low, based on the output gap estimate of the OECD, it should be close to 1.5 percent, and based on the output gap estimate of the Hodrick-Prescott filter, it should even be above 2.0 percent.

Figure 1: Taylor interest rates based on alternative output gap estimate

Increasing Risks of Expansionary Monetary Policy

According to the Taylor rule, monetary policy in the United States has already been too expansionary for several quarters. This is particularly true when interpreting the output gap estimate of the CBO as an extreme estimate, which seems to be add odds with the results of the extensive literature about the medium to long-run effects of financial crises. This literature usually finds that crises have considerable effects on potential output and consequently lead to a smaller output gap estimate. While it is understandable that the Fed decreased the federal funds rate during the financial crisis and the Great Recession very aggressively, it seems to be appropriate to turn now to a more cautious policy, because a too expansionary monetary policy poses several risks. First of all, it poses a risk to price stability, i.e., when it leads to a strong increase in inflation expectations. Moreover, it poses the risk of causing exaggerations on other markets, such as commodity or stock markets, which potentially could lead to a new crisis. Finally, a too expansionary monetary policy poses the risk that the Fed may suffer a considerable loss of credibility, i.e., because the Fed currently finances the bulk of the newly issued government debt. One reason behind the expansionary policy of the Fed is the high unemployment rate, which puts the Fed under large public pressure to react. However, it is very likely that the structural unemployment rate is currently higher than estimated before the crisis, so that the ability of monetary policy to bring employment back to its old levels is limited. Furthermore, the Fed seems to have a lot of confidence in its ability to control the measures of quantitative easing. From a theoretical perspective, this is indeed perfectly possible. However, one should keep in mind that there is very little practical experience with measures of quantitative easing, so that they should not be used excessively.

The Fed Should Start to Prepare the Public for Monetary Tightening

Against this background, it would have been advisable to abstain from Quantitative Easing II and to begin with a tightening of monetary policy. However, the Fed had already started with the purchase of additional treasury bonds and announced that it would maintain the federal funds rate at “exceptionally low levels” for an “extended period.” The latter is usually interpreted by financial markets to indicate that the Fed will hold the rate close to zero for at least half a year. Currently, the situation is not so dangerous that the Fed should withdraw these announcements. This would unsettle markets and would lead to a loss of credibility of the Fed. However, the Fed should start communicating that it is prepared to increase the federal funds rate in the autumn of this year. Furthermore, it should not initiate additional measures of quantitative easing, even if the unemployment rate remains high. Rather, the Fed should return to their traditional monetary policy, which is based on inflationary expectations and the output gap, because the acute crisis that has justified the quantitative easing measures lies behind us. Even though output gap estimates are highly uncertain, the Fed should not base its monetary policy on extreme estimates of the output gap such as those of the CBO. Given the current stance of the business cycle, it seems appropriate to start raising rates in autumn. Moreover, the Fed should stop reinvesting the principal payments from its security holdings in treasury bonds and thereby start reducing its balance sheet.

References

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^[1]The ouput gap based on the Hodrick-Prescott Filter was calculated with a value of lambda equal to 100,000. When using the standard value for lambda for quarterly data, which is equal to 1,600, the estimated output gap is considerably smaller; consequently, the calculated Taylor interest rate would be higher. We tried to lessen the end point bias problem by using our own quarterly forecasts for GDP until end of 2012.

*The Kiel Institute Focus Series presents papers on current economic policy topics. Their authors are solely responsible for their content and their views or any policy recommendations they may make do not necessarily represent the views or recommendations of the Institute.