Did Greenspan Have to Cut the Fed Funds Rate as Much?

By: Paul Kasriel | Mon, Apr 7, 2008
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In today's Financial Times, Greenspan is generously given yet another chance to defend his legacy. Greenspan's argument that it was not his doing that set off the U.S. housing bubble reminds me of my two perfect children. When they appeared to err, it was never their fault. Greenspan's main defense lies on the fact that long-term interest rates were falling in the early 2000s due to global factors beyond his control. To start with, let's give him this one. But even if the decline in long rates were beyond his control, did he have to cut the fed funds rate - an interest rate he did control - as much as he did and hold it at the low level as long as he did (see Chart 1)?

Chart 1

Starting in 2001, Greenspan held the fed funds rate below the year-over-year percent change in the median price of an existing single-family home, holding it below house-price appreciation through 2005 (see Chart 2). That is, the real fed funds rate in terms of house-price appreciation was negative from 2001 through 2005, establishing a record low real fed funds rate of minus 9.6% in 2005. Not since the late 1970s had the Fed allowed the fed funds rate to consistently trade below the rate of house-price appreciation.

Chart 2

Mortgage borrowers are not restricted to 15- or 30-year fixed rate loans. If shorter maturity rates are attractive, they can opt for those adjustable rate loans Greenspan was actually touting back in 2004. Chart 3 shows that mortgage borrowers did increasing opt for adjustable rate mortgages in the last housing cycle, in part (see Chart 3), presumably, because Greenspan held down short-term interest rates.

Chart 3

Back to Greenspan's lack of control of long-term interest rates. Although bond yields do march to a different drummer than does the fed funds rate, they still "hear" and are affected by the Fed's drum beat. That is, if the Fed sends a strong signal to the markets that it intends to slash the level of the federal funds rate and hold it at a low level for an extended period of time, these fed funds rate expectations will be factored into the level of bond yields - not one hundred percent, but not zero percent, either. So, Greenspan's argument that he had no control over bond yields is not entirely accurate.

So, as a free market economist, I can only lament that one of the byproduct's of Greenspan's artificially-low interest rate policy will be to discredit the functioning of free markets and bring on more regulation. Thanks, Alan. Ayn Rand must be spinning in her grave.



Paul Kasriel

Author: Paul Kasriel

Paul L. Kasriel
Director of Economic Research
The Northern Trust Company
Economic Research Department
Positive Economic Commentary
"The economics of what is, rather than what you might like it to be."
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Paul Kasriel

Paul joined the economic research unit of The Northern Trust Company in 1986 as Vice President and Economist, being named Senior Vice President and Director of Economic Research in 2000. His economic and interest rate forecasts are used both internally and by clients. The accuracy of the Economic Research Department's forecasts has consistently been highly-ranked in the Blue Chip survey of about 50 forecasters over the years. To that point, Paul received the prestigious 2006 Lawrence R. Klein Award for having the most accurate economic forecast among the Blue Chip survey participants for the years 2002 through 2005. The accuracy of Paul's 2008 economic forecast was ranked in the top five of The Wall Street Journal survey panel of economists. In January 2009, The Wall Street Journal and Forbes cited Paul as one of the few who identified early on the formation of the housing bubble and foresaw the economic and financial market havoc that would ensue after the bubble inevitably burst. Through written commentaries containing his straightforward and often nonconsensus analysis of economic and financial market issues, Paul has developed a loyal following in the financial community. The Northern's economic website was listed as one of the top ten most interesting by The Wall Street Journal. Paul is the co-author of a book entitled Seven Indicators That Move Markets.

Paul began his career as a research economist at the Federal Reserve Bank of Chicago. He has taught courses in finance at the DePaul University Kellstadt Graduate School of Business and at the Northwestern University Kellogg Graduate School of Management. Paul serves on the Economic Advisory Committee of the American Bankers Association.

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