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To What Extent Did Monetary Policy Contribute Towards the Recent Financial Crisis and Subsequent Recession in the US and UK?

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To What Extent Did Monetary Policy Contribute Towards the Recent Financial Crisis and Subsequent Recession in the US and UK? International Research in Economics and Finance; Vol. 3, No. 2; December, 2019 ISSN 2529-8038 E-ISSN 2591-734X Published by July Press To What Extent did Monetary Policy Contribute Towards the Recent Financial Crisis and Subsequent Recession in the US and UK? Tao Hu1 & Ceri Davies1 1 University of Birmingham, UK Correspondence: Tao Hu, 3/77 Albion Road, Box Hill, VIC 3128, Australia. Tel: 61-47-877-6275. Received: October 25, 2019 Accepted: November 14, 2019 Online Published: December 15, 2019 doi:10.20849/iref.v3i2.691 URL: https://doi.org/10.20849/iref.v3i2.691 Abstract This essay researches the question, “To what extent did monetary policy contribute towards the recent financial crisis and subsequent recession in the US and UK?” This article begins by demonstrating monetary policy’s role in guiding the economy’s development under different economic fundamentals. Then the essay puts forward the existence of possibility that monetary policy may cause potential dangers for the economy. In the next chapter, the essay illustrates the guideline for monetary policy namely Taylor rule and economists’ arguments and explanations for the US monetary policy in the past decade. In chapter 3, this article estimates the nominal interest rates for both the US and the UK based on Taylor rule for different periods and illustrates influences of monetary policy actually taken for each country in different periods. In chapter 4, the article tests the relationship between monetary policy’s deviations from Taylor rule and financial imbalances by using the OLS method and explains results. Finally, in chapter 5, the article concludes that in some degree monetary policy’s deviations from Taylor rule prescriptions contribute to a build-up of financial imbalances. Keywords: Taylor rule, deviations, imbalances, bubbles, and regulations 1. Introduction Monetary policy plays an important role in guiding the economy’s activities according to different economic fundamentals. An appropriate set of policy rate can stimulate the economy’s biggest potential, which is potential GDP. Potential GDP is a country’s gross domestic product when it produces at full employment and utilizes its all resources. However over the past two decades, the world economy suffered several crises originated from different sectors and areas. From the Asian financial crisis to the Internet bubble, and to the most recently, the American subprime mortgage crisis, it seems that the world economy falls into the recession-recovery cycle. Viewing the development of the world economy, we can find that during the period from the mid 1980s to 2000, the US economy developed quite well with low volatility of real GDP growth and low inflation. We may call this period the Great Moderation. For awakening the deteriorative economy, analyzing what we had done during the Great Moderation and learning from it may be an effective method. By comparing the monetary policy between the Great Moderation and in recent years, we find that monetary policy may cause dangers for the economy unintentionally. In other words, monetary policy during the past decade aimed at reaching stable inflation rate, while it also buried a time bomb for the economy. Thus analyzing the relationship between monetary policy and financial crisis is quite important and useful for further economic analyses and decision makings. 2. Literature Review 2.1 Introduction of Taylor Rule Monetary policy is a quite important and useful instrument for policy makers to adjust the nation’s economy situation for both current and future. The Taylor rule has become the key benchmark for the central banks to regulate the economy through the interest rate instrument during the past decades. John B. Taylor first proposed the rule in 1993. It prescribes a simple rule for policymakers to change the nominal interest rate in response to the gap between actual inflation and target inflation as well as the output gap. Taylor (2008) concludes that there is a host of advantages originating from making the monetary policy based on a simple rule such as the Taylor rule. Two of them are more or less essential for central banks to consider. First, the simple rule helps policymakers to be easier to communicate with the public about how and why their decisions are made. Second, the simple rule helps ensure that policymakers’ short-run actions are consistent with their long-run goals, which 9 http://journal.julypress.com/index.php/iref Vol. 3, No. 2; December, 2019 are stable inflation rate and low volatility of real GDP growth rate. These advantages help policymakers to build trust between the general public and the government as well as anchoring inflation expectations. Diamond (2007) points out that distrust may cause alienation and make the general do not follow the government’s guidance. Furthermore, it is hard for government to mobilize all national resources to develop the economy. OECD points out that trust is necessary to increase confidence of investors and consumers; trust is essential for key economic activities, especially finance. Besides the trust, inflation expectations are anchored by conducting the simple rule. Taylor rule recommends a relatively higher nominal interest rate when inflation is above its long run target or when GDP is above potential GDP. For example, when inflation rate is 1 percent higher than the inflation target, Taylor rule recommends the nominal interest rate to be raised more than 1 percent. Since the real interest rate equals the nominal interest rate minus inflation rate, the real interest rate is increased when inflation rate increases. Then the increase of the real interest rate tightens economic activities. For the next period, the inflation rate is expected to reduce. Therefore, for the long run, the public’s expectations of inflation rate are anchored to the long run inflation target. 2.2 Supports for Taylor Rule Deviations Contribute to Financial Crises Kahn (2010) points out that during the Great Moderation the actual federal funds rate closely matched the rate prescribed by Taylor rule. While from late 1990s until now, there is a great deviation between the actual federal funds rate and the prescribed rate. If the deviation from the Taylor rule is small and temporary, it may represent an appropriate and reasonable adjustment to the unexpected economic and financial circumstances. If the deviation from the prescribed rule is large and lasting, it may contribute to facilitating the financial imbalances. Theses imbalances might force a buildup of financial bubbles that will eventually end up with the crises. Taylor (2010) argues that the great deviation plays a significant role in contributing the recent financial crises. Compared with the policy taken during the Great Moderation, the policy now becomes more interventionist and less predictable. The central bank should make decisions that will help to achieve the long-term goals rather than too many interventions that only consider about the current economic and financial conditions. If central banks take too many actions only based on current concerns, it might make the actual funds rate deviate from the Taylor rule prescribed rate inadvertently. Taylor (2010) argues that the interest rate came down in 2001 due to the recession that was acceptable and reasonable, but then the interest rate kept low for a long time before rising. According to principles followed during the Great Moderation, interest rates should have returned much sooner to the neutral level. Thus big deviations were formed during this period. Taylor (2010) states that the low interest rate contributed to the appreciation of housing price. In Taylor (2007), he built a model to test the connection between the low interest rates and housing boom. The results showed that a higher federal funds rate would reduce much of the boom in housing price. Start from early 2000s, the policy rates have been globally below the rate prescribed by the Taylor rule. From Bernanke (2010) speech, we can find that countries like the US, Canada, Greece, Spain, Ireland and Italy deviated from Taylor rule prescriptions for more than 2 percent. Other developed countries like the UK, Australia, Germany and Japan did not deviate much from Taylor rule prescriptions, but their economies were still heavily hit by the 2008 crisis. There is no doubt that when the US economy goes into recession, these countries closely connecting with the US economy will go into recession too. According to Kahn’s (2010) view, a persistent low level of policy rate would potentially form a strong incentive to purchase assets through short-term borrowing among investors. Moreover, it might increase the leverage ratio, risk-taking and speculation among different financial markets. Systematically, this may lead to assets prices and other financial variables deviating from their long-term historical trends persistently. This is the so-called financial imbalance. White (2006) illustrates the opinion in the BIS Working Papers that the modern financial system is inherently procyclical. For example, after a recession, the government might choose a relative low level of policy rate to recover the economy. As a result, the leverage ratio, risk taking and speculation among financial markets may increase. Under this situation, a piece of good news could boost optimism among investors. Thus, it is quite easy to form a bubble in financial markets. Eventually, the bubble bursts, while the economy falls into the recession again. Kahn (2010) estimates the relationships between the deviation of the actual federal funds rate from the prescription of Taylor rule and the financial indicators including changes in the S&P tech stock price index, the house price-to-rent ratio, the broker-dealer leverage ratio and changes in the commodity price index. In his estimation positive deviations mean the actual policy rate is higher than the prescribed rate, vice versa. The results show that except the changes in the S&P tech stock price index, other three financial indicators show an inverse relationship between Taylor rule deviations.
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