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Interest Rates and Crisis: Revisiting the "Taylor Rule"

I Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis, John B. Taylor presents a pointed and often provocative view of the turmoil that has affected global financial markets since the summer of 2007. In this book, the reader will be able to find sharp answers to what caused the 2007 financial crisis, to what prolonged it to 2008, and to what made it worse in the fall of 2008. Taylor argues that the crisis was primarily the result of excessively loose monetary policies in the United States and Europe, and not created by market forces such as excessive savings in Asia. In John Taylor’s view, an overly expansionary monetary policy set by the U.S. Federal Reserve from 2001 to 2006 was the primary cause of the crisis, much like earlier real estate crises in Japan, Norway, Sweden, and Finland in the late 1980s that were fueled by uncontrolled expansion of money and credit.1 In 1993, Taylor published a seminal article that defined what could be considered inappropriately loose monetary policy.2 This device, which became known as the Taylor rule, prescribes that the Federal Reserve should set a target for the federal funds rate that takes into account both inflation and GDP.3 According to evidence presented by Taylor in Getting Off Track, between 2001 and 2006, given the levels of measured inflation and output gap, the federal funds rate was below the prescribed level by as much as three percentage points. While this deviation from a well established monetary policy rule was defended at the time by Fed officials citing deflationary pressures following the 2001 recession, Taylor blames it for accelerating a housing boom which eventually ended with a bust. The claim, supported with empirical evidence, states that had the Fed followed the Taylor rule, the housing market would have peaked in 2003 and the subsequent bust would have been avoided. One explanation for this long period of excessively low interest rates around the globe, to which Taylor gives credit, is the possibility of interactions between the leading central banks of the world when setting targets for the nominal interest rate. In this case, a decision to cut interest rates by one central bank causes other central banks to cut their rates in response and sets in motion a series of cuts. Research by Taylor cited in the book seems to show that there is as much evidence of the European Central Bank (ECB) following the