Business Insider

Peter Crabb: Fed's behavior led to today's crisis, risks inflation later

More often than not, you get what you pay for.

According to economist John Taylor of Stanford University, the Federal Reserve got us the financial instability we see today by buying its way out of the 2001 recession.

Taylor is most famously known for recommending a rules-based economic policy, appropriately called the Taylor Rule. The rule instructs monetary policymakers to set the short-term interest rate in the banking system based on a target inflation rate and the gap between actual and trend gross domestic product.

The theory predicts that we will see better long-run economic growth and less financial price volatility than an approach whereby everyone is guessing what the Federal Reserve will do next. Between 2002 and 2004 interest rates were well below what the rule required and contributed to our problems today.

In a new book, "Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis," Professor Taylor shows that if interest rates followed the Taylor-rule path during this same period, the housing boom would have ended in 2003 because the cost of mortgage debt would have risen much higher.

There is no indication today that policy makers will commit to following rules to achieve more stability in the economy, but they are discussing whether to hold regular news conferences. This would provide more opportunity to hear just what policy or strategy the Fed is following and should lead to less guesswork.

Government actions and interventions like those seen over the last six months can cause, prolong, and even worsen financial crises by creating greater uncertainty. A commitment to more transparency through regular discussions with the public can mitigate this problem.

Meanwhile, European policy makers realize that the excessive increases in the money supply for both Europe and the United States will need to be quickly reversed as soon as the economy picks up. Peer Steinbrück, German finance minister, recently warned that the world will see high inflation, and as Taylor suggests, a "crisis after the crisis," when the global economy recovers.

What is needed to avoid high inflation is for central banks to raise interest rates rapidly. But such quick adjustments to protect against inflation can lead to a quick end to any economic recovery. So far, deflation, not inflation is the order of the day. The Labor Department reported Wednesday that U.S. consumer prices fell 0.1% in March and were down 0.4% from a year ago. This annual decline is the first since 1955.

However, the bond market sees little evidence that price declines will continue. The yield-spread, or the difference between the interest rate on 2-year and 10-year U.S. Treasury notes, remains steady at 1.9 percent. A positive spread suggests rising inflation and interest rates.

Many commodity prices are also continuing their upward trends. Gold prices are up 10 percent from their lows of January.

To date, government policies of easier money and greater federal government spending are sending strong inflationary signals and increasing market price volatility.

Since 2000, Peter R. Crabb has been a professor of finance and economics at Northwest Nazarene University in Nampa. He earned his doctorate in international and financial economics from the University of Oregon.