Monetary Policymakers’ Colossal Non Sequitur

I recently re-came across this economic research memo from Taylor, Schularick, and Jordà from the San Francisco Federal Reserve from a year ago.  The “tl;dr” summary is as follows:  The Federal Reserve’s monetary policy should not share any of the blame for the housing boom and bust associated with the Great Recession.  The Federal Reserve’s monetary policy targeted the short-term federal funds rate.  Given that longer-term rates, i.e. those used to price mortgages, don’t move in perfect harmony with short rates like the fed funds rate, the Fed would’ve had to raise the fed funds rate by 800 basis points in 2002 to prevent the housing boom.  This alone would have caused a recession deeper than the one that actually followed.

FF vs 30Y mortgage.png

This general consensus on pre-crisis monetary policy seems to make sense.  The Fed can’t control mortgage rates directly so the crisis must’ve been caused by Colonel Mustard in the ballroom with the candlestick.  But this glosses over everything going on in the financial system—what the Financial Crisis Inquiry Commission called “The Mortgage Machine” and “The CDO Machine.” (Before proceeding, it is worth noting that this is beside the issues of the Fed’s failure to regulate fraud, Fed monetary policy stoking nominal GDP growth above potential, and the fact that countries like China were recycling easy Fed policy back into U.S. assets—and lowering longer-term U.S. yields—to keep their home currencies depreciated.  The latter two issues have been well-addressed by David Beckworth of the Mercatus Center here, among other places.)

While it’s true the federal funds rate isn’t directly used to price mortgages, the ability of banks to unload the mortgages they wrote to securitizing firms rapidly certainly affects mortgage rates as it increases the capital available for mortgage loans.  These firms were financing the process of buying these loans and creating mortgage-backed securities (MBSs) and their associated collateralized debt obligations (CDOs) in the short-term paper markets.  Unlike mortgage rates, interest rates in these markets largely tracked movements in the fed funds rate: FFR vs Comm Paper Rates.png

Weak regulation of the asset-backed commercial paper market combined with low interest rates allowed this market to grow unabated in the lead-up to the crisis (see figure below).  In the absence of higher regulatory capital charges for this type of debt, higher short-term interest rates would have eaten into the capital of the firms using this short-term funding market to finance their creation of increasingly risky MBSs and CDOs.AB Comm. Paper Outstanding
Without the MBS and CDO machines functioning uninterrupted, banks would not have been able to extend as many home loans (to increasingly risky borrowers) and we wouldn’t have seen the massive rise in house prices and household debt that culminated in the Great Recession.  Is monetary policy the sole cause of the Great Recession?  Absolutely not.  But monetary policymakers weren’t nearly as helpless as is commonly assumed.


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