And joint distributions with independence in the central mass but high correlation in the tails are likely to be extremely hard to model and calibrate. Monetary policy Other macroeconomic features also probably contributed to the growth in credit leading up to the crisis. In particular, according to some monetary policy was too loose over this period, especially in the United States (see Taylor, 2007). Fig. 6 shows the difference between the policy rate and benchmark estimates of an “appropriate” policy rate derived from a Taylor rule. Notwithstanding the usual caveats about the construction of such benchmarks, the very low level of the Federal Funds rate relative to the Taylor rule during 2001-5 is striking. Of course, the FOMC held rates this low for a reason – they were concerned about entering a Japanese-style deflation and in order to mitigate that risk committed to holding the policy rate at a low level for a sustained period so as to pull down longer-term market interest rates. There is, though, little to suggest that policy rates were noticeably out of line in the euro area and the United Kingdom. Credit was nevertheless growing rapidly, as documented earlier in Fig. 1. Despite generally low and stable inflation, that led some – most notably Bill White and colleagues at the Bank for International Settlements (Borio and White, 2003; White 2006) – to argue that the credit/asset-price boom was storing up trouble for the future.
In particular, access to a cheap source of manufactured goods as result of the rapid development of China and other emerging market economies created a terms of trade gain for the advanced countries and a beneficial “tailwind”, which only mutated into a “headwind” towards the end of the period as rapid global growth put upward pressure on oil and other commodity prices. Second, changes in the structure of the economy could have meant that similar sized shocks had smaller macroeconomic effects. Candidate structural changes included the shift from manufacturing to services, tighter control of inventories leading to an attenuation of the inventory cycle, increased competition in product and labour markets, and innovation in financial markets that facilitated the greater spreading of risk and an enhanced ability to smooth spending in the face of shocks to income or wealth. A final possibility is that better macroeconomic policies, including improved policy frameworks, had moved economies closer to the eponymous Taylor frontier which traces out the lowest achievable inflation volatility for a given volatility of the output gap. In particular, earlier periods were bedevilled by monetary policies that had failed to anchor inflation expectations. But the pursuit of inflation targets and similar stability-oriented monetary policies by independent central banks seemed to have been more successful in anchoring inflation expectations. Now if the Great Moderation was down to “good luck”, then improved macroeconomic performance was more likely to be ephemeral. But if it was down to structural changes or better policy, there was more chance of it proving permanent.