How much did low interest rates matter?

It is popular to attribute the credit boom (at least in part) to the Federal Reserve having kept the federal funds rate "too low for too long," but comparison of the path of the funds rate in Figure 5 with the measures of credit growth in Figure 1A shows that the increase in lending was greatest in 2006 and the first half of 2007, after the federal funds rate had already returned to a level consistent with normal benchmarks.

That is Michael Woodford from the Journal of Economic Perspectives.


Well, if you assume that both lending standards declined (because lenders were willing to assume more risk--and that houses were in a bubble--the fact that lending standards were normal in 2006/7 is irrelevant because the two other factors against which you lend--the lending standards and the housing asset--were off, due to the earlier lower interest rates.

Interest rates without reference to the value of the underlying asset and without reference to the debtors risk profile are just like an image in a house of mirrors.

If I wanted to be cute I could say the market assumed a competent Fed. The punch line is 'go look at Figure 5."

It's a momentum game.

Tend to confirm the endogenous banks money theories that say lending is often higher when the central bank interest rate is higher, since its now profitable to make less-sounds loans. That also fits the dynamic of the peak of the housing bubble where the really batshit crazy lending only really got going in 2004-06.

Agree with most of the above comments.

Shame on you for a two-variable static analysis. The bubble didn't begin when the bubble was biggest. It began many years - about a decade - before house prices peaked.

It began in the mid-90s with enormous government and GSE subsidies for housing, particularly low-income housing. The prolonged low interest rates in the early 00s certainly contributed to both cheap funding sources and a search for yield. Global trade imbalances created enormous dollar reserves looking for a place to park, and MBS offered attractive yields at seemingly low risk for those reserves.

The Fed began raising interest rates in June 2004, but the bubble kept growing. The momentum of the bubble and warped incentives caused a market failure.

If rates had risen sooner and faster, the cost of funding would have gone up and cut off loan supply. The cost of borrowing would have gone up, reducing demand. Higher treasury rates would have reduced the relative yield of MBS.

There is no single cause, but it would be a huge mistake to say that low interest rates from monetary policy wasn't a large contributing cause. It would be further error to believe that rising rates would not have ended the bubble sooner and cheaper.

"Benchmarks" mean nothing. This hardly proves that interest rates were not too low. If the benchmarks were too low, then interest rates were too low. And interest rates are too low if they are encouraging risky behavior in a high-risk environment. Of course, the only way to know what real interest rates should have been would have been to have had unmanipulated interest rates in the first place.

Don't get carried away folks. It's wrong on a lot of levels, but it's one paragraph from a paper.

If you look at figure 5 one obvious question that jumps out is what should the Fed have raised the interest rate to? It's almost obvious that the increase was knee-jerk over-control, but did they raise it too high, precipitating the crash once the loans could no longer cash flow the asset levels? Housing prices surely had to fall regardless, but could they have created a soft landing? If you look at that almost ridiculous spike in The Fed rate (If I were to make up an exaggerated cartoon on Fed over-control I couldn't do much better, and noone would believe it) you have to conclude that it's a possibility.

"Wow. Now that I know the facts, I am really sorry to have been one of those naive economists who thought the Fed had something to do with it."

Because you don't get it. The 'credit boom' goes way beyond 10 years or even 15 years ago. It started in 1973 and people still don't get that.

Somebody needs to make a book on the historic credit expansion itself and its end. But I figure that will not be to the 2020's or 30's when event is further behind in the mirror.


Much of the lending growth in '06-'07 resulted from credit agreements that were put into place in '04-'05.

@The Rage

Raghuram Rajan's book "Fault Lines" touches on this. He traces one of the root causes of the crisis all the way back to the emergence of export-led development strategies in the early 80s.

He also says the credit expansion is a political palliative for widening income inequality and generally slow income growth. I do not agree that income inequality was a factor, but income growth likely was. People care greatly how their incomes grow. They may want to keep up with the Joneses, but they have no allusions about keeping up with the Gateses, Buffets, Ellisons, and Brins.

The rate hikes were the first signs that a Minsky moment was upon us. A Minsky analysis is applicable to this situation as stability encouraged financial innovations, such as mortgage backed securities, that led to a great increase in leverage ratios and increasing competition to originate loans. Lending standards were notoriously lax because mortgage backed securities caused the originators of these loans to worry little whether their customers could pay or not. Competition among banks paved the way for easy credit and even more lax lending standards. Home prices were bid up, and rising prices encouraged more financial innovation and yet more leverage, both financial and household, as homes could always be refinanced or sold for higher prices later if the going got rough. These are the stages of Minsky's Financial Instability Theory, from hedge to speculative and finally to the Ponzi stage, which would have been in 2006 and 2007 when the rate hikes occured. Borrowers began to take out home equity loans to keep up their already unsustainable spending and payments on previous debt. According to Minsky, a Ponzi stage ends when interest rates rise or asset prices decrease. In this case, both happened in 2007, leading to our current recession.

I'd be interested in what percentage of home buyers were empty-nester boomers. They are such a large population that everything they do can shift the markets in fundamental ways. If they all trade up to houses in the cities or buy McMansions in the suburbs because interest rates are at all time lows and they're at a point in their lives when they can easily take advantage of them it can lead to an entire market shifts.

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