Did the Fed Go Too Low Too Long?

Congressman Ron Paul is one quirky cat.

I can't say that I agree with him when it comes to his calls to abolish the Federal Reserve, and I'll admit to giggling sometimes when he makes off-the-wall comments. However, I do listen intently when he gets a chance to question Fed Chairman Ben Bernanke, because his pointed challenges of the Fed and Fed policy can stir up some interesting discussion (as opposed to the snooze-inducing dreck that often permeates governmental hearings).

Yesterday, Paul challenged Bernanke on whether the extended period in which the Fed kept rates low at the beginning of the decade led to the housing and credit bubbles. His questioning became the latest reverberation of the "too low too long" debate.

Why "too low too long" matters
In the eyes of economists, all of us react to various economic incentives. As a driver of interest rates, the federal funds rate is a key variable in encouraging people to act a certain way.

Think about it this way: If a low federal funds rate pushes down borrowing costs for JPMorgan Chase (NYSE: JPM  ) , it may feel OK about lowering your credit card interest rate. Once that happens, you may suddenly be more apt to carry a bigger card balance (not that that's ever really a good idea). Since you feel like you have a bit more money to spend, you may decide that it's a good time to head to Best Buy (NYSE: BBY  ) to buy the big-screen TV you've been eying.

That one purchase may not make a huge difference, but multiply that over a whole bunch of consumers, and you may be moving a serious number of TVs. Best Buy, for its part, may decide that this increase in demand requires new stores, which, by the way, can be financed with low borrowing costs.

Those new buildings could be part of an overall boost in steel demand for manufacturers like Nucor (NYSE: NUE  ) . At the same time, TV manufacturers like Sony may see sales go up, and they in turn could kick the good times out to suppliers like Corning (NYSE: GLW  ) .

All of that comes back to incentives. If interest rates are held too low, they can artificially increase demand, encourage companies to produce based on that heightened demand, and get banks to lend to all sorts of borrowers who shouldn't be borrowing. In short, unnaturally low rates could throw the whole system off kilter.

Supporters of the "too low too long" argument would say that the mess we've seen with homebuilders like Toll Brothers (NYSE: TOL  ) and KB Home (NYSE: KBH  ) and lenders like JPMorgan and Citigroup (NYSE: C  ) is all fallout from misguided policy decisions.

No easy answer
Paul's volley about "too low too long" is hardly the first. Debate still percolates about not only whether rates were kept too low, but if they were, whether they really could have caused the housing bubble.

Besides Bernanke, one economist who's been front and center in the debate is Stanford professor John Taylor. He's particularly notable here because he cooked up the so-called "Taylor Rule," an equation based on inflation and the gap between current economic production and "optimal" production that spits out a recommended federal funds rate target.

Taylor and Bernanke have been at odds over the best way to use the Taylor Rule in guiding the Fed in policymaking decisions. While Taylor sticks to the method he's always used to calculate the optimal target rate, Bernanke and the Fed have been following a slightly tweaked version that uses different constants and forecast (instead of current actual) inputs.

The debate may sound a bit dry and academic, but the implications are anything but. Over the past year, calculations of the Taylor Rule by the Fed have been significantly different than what Taylor's approach would come up with. That is moot for now, because both have had negative results, and the Fed can't drop rates lower than zero.

However, as inflation begins to rise and the economy continues to recover, those disparate conclusions could potentially mean big differences in the way policy is carried out. And if you believe that rates were kept "too low too long" the first time around, it could mean playing that same record all over again.

So what do you think? Were rates kept "too low too long" the first time around? Will the Fed fall into that trap this again? Scroll down to the comments section and share your thoughts.

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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 19, 2010, at 10:17 AM, jmt587 wrote:

    Yes and yes.

  • Report this Comment On March 19, 2010, at 11:06 PM, MichalTod wrote:

    History has already shown they were kept too low for too long. As for whether the fed has learned its lesson, one can only hope so.

  • Report this Comment On March 20, 2010, at 12:03 AM, dinobaba wrote:

    It wasn't only "the beginning of the decade" that rates were too low for too long. It was Greenspan's irrational low interest rates that led to the resulting RATIONAL exuberance that led to the 90s tech bubble. That's where the trouble began.

  • Report this Comment On March 20, 2010, at 12:22 AM, dinobaba wrote:

    OK I exaggerated, the exuberance was irrational too but the interest rates were still too low

  • Report this Comment On March 20, 2010, at 2:13 AM, TMFKopp wrote:

    @MichalTod

    "History has already shown they were kept too low for too long."

    How so?

    @dinobaba

    Except for dipping to 4.75% between Nov 1998 and June 1999, Greenspan had the Fed Funds target at 5% or better between 1995 and 2000. (http://www.federalreserve.gov/fomc/fundsrate.htm)

    Plus, if you subscribe to the Taylor rule, it appears that Greenspan might have actually set rates above where the Taylor Rule would have recommended. (http://www.frbsf.org/econrsrch/econrev/98-3/3-16.pdf, graph on page 3).

    What would you have suggested Greenspan do?

    Matt

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