Taylor Rule and Fed Witches’ Brew

By Chidem Kurdas

Bubble, bubble, toil and trouble—that’s an apt metaphor for the Federal Reserve policies meticulously dissected by Stanford professor John Taylor, in the Wall Street Journal and other places.  He shows that the Fed set the financial crisis in motion and then made it worse.

Relative to the pattern that held since 1987 – a standard that has come to be known as the Taylor Rule – the Fed kept interest rates exceptionally low in 2002-2006.  Easy credit got real estate prices bubbling, which convinced folks that property prices go only one way and concealed the risk of price declines. Hence homeowners, developers and banks over-extended themselves.

Once the credit bubble collapsed in 2007, the excessive debt became rancid. Taylor argues that the Fed mis-diagnosed the problem as a lack of liquidity. Once again opening the spigot and cutting US rates, it brought down the US dollar. The price of oil, being denominated in dollars, consequently went through the roof. That wrecked household budgets and people responded by curtailing consumption. Thus economic conditions worsened. Continue reading