The productivity gap: Productivity surges as a source of monetary excess

It is widely believed that, in the wake of the dot-com crash, the Fed kept the federal funds target rate too low for too long, thereby inadvertently contributing to the subprime boom.  According to this view, the boom would have been less pronounced and the consequent bust less severe, had the Fed's stance been less accommodative.  We propose an explanation for the Fed’s conduct, and also for its inadvertent contribution to previous business cycles, by linking departures from a “neutral” policy stance to exceptional rates of total factor productivity growth. We use a simple theory of neutral rate changes to argue that the Fed frequently fail to make theoretically appropriate changes to the federal funds target in response to productivity surges and setbacks, and in particular that its response to the post-2001 productivity surge was not only inadequate but perverse.  We supply empirical support for our assessment by comparing our productivity-growth based measure of Fed departures from neutral policy to that implied by the Taylor rule, as well as to measures of both housing market activity and the output gap.