In his recent post at Econlog Scott Sumner writes “Questions that have no answers”:

There are some questions that have no answers. One example is the question: “Was monetary policy too expansionary during the housing boom?” The only sensible answer is “it depends.” It’s not clear what the Fed was trying to do during this period. If we knew, we could evaluate whether the policy was too loose or too tight to achieve their policy goal. …What are we to make of the 2% inflation rate? One could argue the Fed has been successful. After all, 2% is their target. But I believe that’s wrong for 3 subtle reasons.

His third reason:

3. The third problem with the Fed policy is that inflation is the wrong target, they should target NGDP growth, level targeting. It turns out that the NGDP growth rate that kept inflation right at 2% over the past 10 1/2 year was only 4%, well below the 5.4% rate of 1990-2007. And yet, at the very moment when they needed to downshift NGDP growth to 4% to keep inflation on target, the Fed upshifted to more than 6.5% NGDP growth during the housing boom of 2003-06. The third mistake allows us to better understand the mild dispute between some market monetarists over whether Fed policy was too tight loose in 2003-06. David Beckworth says yes, growth was above 5%. Marcus Nunes says no, there was some catch-up from the 2001 recession, and it’s level targeting that matters. In my view there is no answer to this question. If the Fed had continued along the level target path that Marcus suggests, then he would have been right, the policy would have been fine. Given the Fed wanted 2% inflation, Beckworth’s advice would have been better in retrospect. If the Fed went even further and switched to 4% NGDP growth in 2003, then the recovery would have been agonizingly slow, John Kerry would have won Ohio and the Presidency in 2004, and there would have been no Great Recession of 2008. It would have looked like a bad Fed policy in retrospect because of the very slow recovery. The policy would have been condemned by many people, but it would have been far superior to the actual policy.

I hope some illustrations help to clarify matters.

The first thing I want to take out of the way because it is irrelevant to the story is “the housing boom of 2003-06”. It´s really a housing boom of 1997-06 as the chart indicates, independent of what was happening to either interest rates or NGDP growth.

There is an almost universal consensus that monetary policy was “too easy” in 2003-06. My argument is that it was not. Let´s see:

1 NGDP growth tumbled following the 2001 recession

2 The NGDP gap widened up to mid-2003

3 Core inflation went down significantly below target while headline inflation after 2003 reflected oil and commodity price increases (to which Greenspan, correctly, did not react!)

The FOMC meeting of August 2003 introduced forward guidance (“rates will remain low for an extended period, followed later by “rates will rise at a measured pace”). Note that from that point NGDP growth picks up. To close the gap it has to grow more than the 5.4% trend growth rate.

By the time Greenspan was replaced with Bernanke the gap had closed.

This is what happened during Bernanke´s stewardship:

1 After initially remaining close to trend, NGDP growth tanks

2 The gap becomes gargantuan

3 It appears (1) and (2) above were the result of the Fed´s (mistaken) reaction to headline inflation

The rest is ‘history’.

Update: Karl Smith argues along the same lines