International Monetary Fund Paper Counters Raghuram Rajan on Easy Policy Being Recipe for Crisis

"One last ingredient can make the cocktail particularly volatile, and that is, low interest rates after a period of high rates - either because of financial liberalisation or because of extremely accommodative monetary policy," Dr Rajan had said at that time, but his warnings were dismissed by the most and some even called him "Luddite" for airing such views.

In their latest IMF Paper, the two economists said some observers have assigned to monetary policy a key role in exacerbating the severity of the global financial crisis of 2007-09.

"Despite a somewhat widely shared common sentiment that the Federal Reserve is partly to blame for the housing bubble, the issue is highly controversial in academia and the policy community," they said.

While some observers support the idea that monetary policy contributed significantly to the boom that preceded the global financial crisis, others argue against this thesis.

"To address some of these issues, we developed a simple model of consumption-based asset pricing with collateralized borrowing, monopolistic banking, real interest rates rigidities and pecuniary externalities," they said.

The first argument - that higher interest rates would have reduced both the probability and the severity of the great recession - is justified only with an "auxiliary assumption that the Fed had to address all distortions in the economy with only one instrument, namely the policy interest rate".

Under former Chairman Alan Greenspan, the US Federal Reserve lowered its benchmark rate from 6.5 per cent to about 2 per cent in 2000-01 as a response to the burst of the dot-com bubble. It further lowered rates to 1 per cent in 2002-03 in response to a deflationary scare, and finally started a long sequence of tightening actions that, during 2004-06, brought the rate back to 5 per cent.
     
It has been argued that the Fed helped inflate US housing prices by keeping rates too low for too long after 2002 and as a consequence, those low rates were a factor in the housing boom and therefore, ultimately the bust.

"Therefore, according to this view, higher interest rates would have reduced both the probability and the severity of the bust that led to the Great Recession," the Paper said.
     
However, this contention that "excessively lax monetary policy might have contributed to the occurrence and the severity of the Great Recession" does not appear justified.
     
While the monetary policy was appropriately targeting macroeconomic stability, the regulatory function of the system, instead, was "at best ineffective in addressing the financial imbalance that continued to grow in the subprime mortgage market while monetary policy was tightened in 2004-05", the two economists said.
     
"With the fall in interest rates after the burst of the dot-com bubble and with house prices at bubble-inflated levels, the mortgage industry found creative ways to expand lending and make large profits.
    
"Government regulators maintained a hands-off approach for too long... policy measures aimed at tightening a largely unregulated sector of the US mortgage market kicked in much later than the tightening of monetary policy enacted by the Federal Reserve," they wrote in their Paper.
     
The two concluded that the interest rates can be lowered as much as needed in response to a contractionary shock without concerns for financial stability, when the policy authority has two different instruments.

"This is consistent with the view of (former Fed Chairman Ben) Bernanke that additional policy tools, to limit dangerous expansions in leverage, were needed to prevent the global financial crisis," they added.
 

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