Did the Fed raise interest rates too much too quickly?

Michael Mandel thinks so.

Here’s a thought…maybe part of the reason the credit markets are in such bad shape because the Fed raised rates too fast and too high. Think about it—they started raising rates in June, 2004. It was a quarter point increase, from 1 to 1.25. Two years later, the Fed funds rate was up to 5.25. That’s four percentage points in only two years.

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Basically the Fed took a sledgehammer to the subprime sector in order to slow the economy…they should not be surprised that it broke.

In retrospect it would have been better for the Fed to have stopped at 4% and waited for a while to see what happened. If we assume that it takes 12-18 months for the effect of rate changes to propagate through the economy, they basically showed too much impatience.

I'm not so sure. My main beef during the long, slow rate increase was that they got boxed into a corner with their "measured pace" language. They might have been better off raising the funds rate a little faster at first rather than dragging it out for two years. The measured pace gave the bubbling real estate market more time to ferment into a potent brew. "Sledgehammer" isn't the word I'd use for Greenspan's handling of the situation.

Besides, the teaser rates would have reset anyway, and that's the real problem. Felix Salmon is also skeptical of Mandel's argument.

That's not to say that rates maybe are a little on the high side even now (though the 1.25% shaving last month gets us closer to the sweet spot). In fact, I raised this point tonight at this event with our students. I showed a graph of the Taylor rule and how rates were below what the rule implied in 2003 and recently went a bit above what the rule implied as the economy slows. I'm still a hawk, but even a hawk knows to back down once the tide has turned. Richmond Fed president Lacker would be another case in point. From Reuters:

Lacker said on Tuesday more rate cuts may be necessary to hold off a downturn.

"The prominence of downside risks means that further easing ultimately may be warranted," Lacker said.

However, he added that if economic indicators are not weaker than expected over the next several months, "it's not clear further rate cuts would be warranted."

and...

A well-known inflation hawk, Lacker said persistently high levels of inflation continue to trouble him and limit the Fed's choices in thwarting recession.

"It implies that one doesn't ease as aggressively as one otherwise would," he said.

Well said.