What wrong has Greenspan done?
Professor, CCER at Peking University
Among various explanations of current crisis, the interest cutting taken by Greenspan at the beginning of this century has been considered one of the most crucial reasons. Professor Lu reappraises this assertion through a retrospect of the Fed's monetary policies since the 1950s.
The federal fund rate has been cut from 6.5% in July 2000 to 1% in July 2003 and remains at that level until June 2004. Although the 550 bps cut is only about the average of the twelve interest rate cuts by the Fed since 1953, the federal fund rate after cutting reaches the lowest level ever since 1963. Furthermore, the proportion of interest cut, more than 80% of the previous peak, is among the largest.
Federal fund rate is the primary instrument of the US monetary policy. Basically, it can be explained by two variables, inflation rate and growth rate, as characterized by the Taylor's Rule. Under the Taylor's Rule, short term rates are adjusted according to previous inflation rates. Generally, negative real interest rates should be avoided. However, the real interest rates had been negative for three and half years between the beginning of 2002 and August 2005. Negative interest rates became more severe if headline CPI rather than core CPI is examined.
Usually, as the Fed policies are contractive, long term interest rates rise along with short term rates. However, it was different when the Fed raised federal fund rates since June 2004, recognized as a conundrum by Greenspan in his autobiography. The conundrum is somewhat the result of globalization and outsourcing activities. On the other hand, abundant capital provided by foreign countries strengthened the market's belief that long term rates have been pushed downward permanently.
Financial crisis is the outcome of many factors including human behavior, regulation, environments and so on. The long-lasting low interest rates allured investors investing heavily on illiquid assets. Current monetary policy rule is also problematic. Emphasis on core inflation and ignorance of asset prices lead to an overexpansion of credit. Wrong expectation of the market aggravates the crisis.