In the wake of the 2007-9 financial crisis a narrative has emerged, especially for the United States, that poses a new challenge to the joint conduct of monetary policy and financial regulation. This narrative places much of the blame for the crisis, and therefore the economic costs that the aftermath of the crisis inflicted (and continues to inflict) not just in the U.S. but elsewhere around the world as well, on the easy monetary policy that the U.S. Federal Reserve System pursued during the early years of that decade.
In brief, the cause-and-effect sequence posited by this reasoning is that the Federal Reserve set short-term interest rates at historically low levels, in an effort to stimulate economic activity and thereby avert a perceived threat of deflation; that low short-term interest rates spurred investors to seek higher rates of return, for some (mostly individuals) by investing in assets such as houses and for others (mostly institutions) by lending to finance such investments; that this debt-financed investment bid up the prices of houses and other assets, at first in the usual way but in time also via a bubble-like dynamic in which both the investments and the loans behind them made sense only on the assumption of yet further asset price increases; that after the prices of houses and other assets reached levels sufficiently out of line with fundamental economic criteria the bubble proved unsustainable and asset prices started to fall; that without the rising prices the investors who had borrowed to finance their purchases of these assets could no longer either service or refinance their obligations, especially for home mortgages; that borrowers’ defaults on these obligations, and even more so the mere prospect of further defaults, caused the value of securitized claims against them to fall; and that banks and other highly leveraged financial institutions owned enough of these obligations and claims, and were sufficiently impaired by their decline in value, that a financial crisis ensued. Further, the response to the crisis by the Federal Reserve together with other central banks, intended both to resist the consequent decline in economic activity and to help preserve the integrity of leading financial institutions, was once again to lower short-term interest rates – in the event, to a level below what, under this reasoning, had started the perverse cumulative dynamic in the first place.
