The below excerpt is from Bullard’s research paper that is shaping current Fed policy. He is speaking in regards to the historical application of low interest rate policy to boost a sluggish economy. Ironically he uses “success” of the post dot com/ 9/11 Greenspan policy to justify the current low interest rates:
“These data are labeled .2003-2004 and are associated with a policy rate at 1.0 percent and the inflation rate between 1.0 and 1.5 percent. This episode was the last time the FOMC worried about a possible bout of deflation.
Thornton shows that the longer-run expected inflation rate, as measured from the 10-year Treasury inflation-indexed security spread, was 1.74 percent during the period from January 2001 through April 2003, before any of these statements were made. After the statements, from January 2004 to May 2006, the longer-run inflation expectation averaged 2.5 percent.
In the event, all worked out well, at least with respect to avoiding the unintended steady state.12 Inflation did pick up, the policy rate was increased, and the threat of a Japanese-style deflationary outcome was forgotten, at least temporarily. Was this a brilliant maneuver, or did the economic news simply support higher inflation expectations during this period?”
I’m amazed it is even a question if the low interest rates from the Fed fueled the housing boom. Unfortunately our monetary leaders must not have read Bastiat or Henry Hazlitt to be able to imagine the “unseen” as well as the “seen.” Our world is so full of variables and unknowns that it is easy to shift blame on externalities, but a little deductive reasoning can go a long ways.
A Keynsian recently proposed to me the idea that low interest rates don’t distort the structure of production unless capacity utilization is high. I am inclined to think he is flat out wrong or confusing capital structure with a pre-determinant of inflation. Of course artificially low interest rates distort production, as was the case with the housing bubble, houses were built that shouldn’t have been, people were employed in more construction jobs than should have been, the easy credit and rising prices made people think that buying a house to live in was an investment due to perpetually rising prices. Now people are losing their homes and people who were employed in the housing industry are coping with cut demand for their specialized services. Which leads me to my next point; “cyclical unemployment” is actually under-reported “structural unemployment.” Land, labor and capital was committed to malinvestment that needs to be liquidated. But just as some capital goods are specialized, so their use is limited, so are people’s job skills. If you spent the last five years building houses in Las Vegas, it might be difficult to move to a new sector in an already competitive labor market. Just as the Greenspan interest rates enabled a boom in the housing market, the Bernanke rates are enabling a boom in government. When interest rates rise and people are less willing to lend to the government the state and federal governments will face a funding crisis and be forced to cut back.