Chairman Ben S. Bernanke
At the Annual Meeting of the American Economic Association, Atlanta, Georgia
January 3, 2010
Monetary Policy and the Housing Bubble
PDF version (354 KB)
The financial crisis that began in August 2007 has been the most severe of the post-World War II era and, very possibly–once one takes into account the global scope of the crisis, its broad effects on a range of markets and institutions, and the number of systemically critical financial institutions that failed or came close to failure–the worst in modern history. Although forceful responses by policymakers around the world avoided an utter collapse of the global financial system in the fall of 2008, the crisis was nevertheless sufficiently intense to spark a deep global recession from which we are only now beginning to recover.
Even as we continue working to stabilize our financial system and reinvigorate our economy, it is essential that we learn the lessons of the crisis so that we can prevent it from happening again. Because the crisis was so complex, its lessons are many, and they are not always straightforward. Surely, both the private sector and financial regulators must improve their ability to monitor and control risk-taking. The crisis revealed not only weaknesses in regulators’ oversight of financial institutions, but also, more fundamentally, important gaps in the architecture of financial regulation around the world. For our part, the Federal Reserve has been working hard to identify problems and to improve and strengthen our supervisory policies and practices, and we have advocated substantial legislative and regulatory reforms to address problems exposed by the crisis.
As with regulatory policy, we must discern the lessons of the crisis for monetary policy. However, the nature of those lessons is controversial. Some observers have assigned monetary policy a central role in the crisis. Specifically, they claim that excessively easy monetary policy by the Federal Reserve in the first half of the decade helped cause a bubble in house prices in the United States, a bubble whose inevitable collapse proved a major source of the financial and economic stresses of the past two years. Proponents of this view typically argue for a substantially greater role for monetary policy in preventing and controlling bubbles in the prices of housing and other assets. In contrast, others have taken the position that policy was appropriate for the macroeconomic conditions that prevailed, and that it was neither a principal cause of the housing bubble nor the right tool for controlling the increase in house prices. Obviously, in light of the economic damage inflicted by the collapses of two asset price bubbles over the past decade, a great deal more than historical accuracy rides on the resolution of this debate.
The goal of my remarks today is to shed some light on these questions. I will first review U.S. monetary policy in the aftermath of the 2001 recession and assess whether the policy was appropriate, given the state of the economy at that time and the information that was available to policymakers. I will then discuss some evidence on the sources of the U.S. housing bubble, including the role of monetary policy. Finally, I will draw some lessons for future monetary and regulatory policies.1
U.S. Monetary Policy, 2002-2006
I will begin with a brief review of U.S. monetary policy during the past decade, focusing on the period from 2002 to 2006. As you know, the U.S. economy suffered a moderate recession between March and November 2001, largely traceable to the ending of the dot-com boom and the resulting sharp decline in stock prices. Geopolitical uncertainties associated with the terrorist attacks of September 11, 2001, and the invasion of Iraq in March 2003, as well as a series of corporate scandals in 2002, further clouded the economic situation in the early part of the decade.
Slide 1 shows the path, from the year 2000 to the present, of one key indicator of monetary policy, the target for the overnight federal funds rate set by the Federal Open Market Committee (FOMC). The Federal Reserve manages the federal funds rate, the interest rate at which banks lend to each other, to influence broader financial conditions and thus the course of the economy. As you can see, the target federal funds rate was lowered quickly in response to the 2001 recession, from 6.5 percent in late 2000 to 1.75 percent in December 2001 and to 1 percent in June 2003. After reaching the then-record low of 1 percent, the target rate remained at that level for a year. In June 2004, the FOMC began to raise the target rate, reaching 5.25 percent in June 2006 before pausing. (More recently, as you know, and as the rightward portion of the slide indicates, rates have been cut sharply once again.) The low policy rates during the 2002-06 period were accompanied at various times by “forward guidance” on policy from the Committee. For example, beginning in August 2003, the FOMC noted in four post-meeting statements that policy was likely to remain accommodative for a “considerable period.”2
The aggressive monetary policy response in 2002 and 2003 was motivated by two principal factors. First, although the recession technically ended in late 2001, the recovery remained quite weak and “jobless” into the latter part of 2003. Real gross domestic product (GDP), which normally grows above trend in the early stages of an economic expansion, rose at an average pace just above 2 percent in 2002 and the first half of 2003, a rate insufficient to halt continued increases in the unemployment rate, which peaked above 6 percent in the first half of 2003.3 Second, the FOMC’s policy response also reflected concerns about a possible unwelcome decline in inflation. Taking note of the painful experience of Japan, policymakers worried that the United States might sink into deflation and that, as one consequence, the FOMC’s target interest rate might hit its zero lower bound, limiting the scope for further monetary accommodation. FOMC decisions during this period were informed by a strong consensus among researchers that, when faced with the risk of hitting the zero lower bound, policymakers should lower rates preemptively, thereby reducing the probability of ultimately being constrained by the lower bound on the policy interest rate.4
Evaluating the Tightness or Ease of Monetary Policy
Although macroeconomic conditions certainly warranted accommodative policies in 2002 and subsequent years, the question remains whether policy was nevertheless easier than necessary. Since we cannot know how the economy would have evolved under alternative monetary policies, any answer to this question must be conjectural.
One approach used by many who have addressed this question is to compare Federal Reserve policies during this period to the recommendations derived from simple policy rules, such as the so-called Taylor rule, developed by John Taylor of Stanford University (Taylor, 1993). This approach is subject to a number of limitations, which are important to keep in mind.5 Notably, simple policy rules like the Taylor rule are only rules of thumb, and reasonable people can disagree about important details of the construction of such rules. Moreover, simple rules necessarily leave out many factors that may be relevant to the making of effective policy in a given episode–such as the risk of the policy rate hitting the zero lower bound, for example–which is why we do not make monetary policy on the basis of such rules alone. For these reasons, even strong proponents of simple policy rules generally advise that they be used only as guidelines, not as substitutes for more complete policy analyses; and that, to ensure robustness, the recommendations of a number of alternative simple rules should be considered (Taylor, 1999a). That said, as much of the debate about monetary policy after the 2001 recession has made use of such rules, I will discuss them here as well.
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Vice Chairman Donald L. Kohn
At the Brimmer Policy Forum, American Economic Association Annual Meeting, Atlanta, Georgia
January 3, 2010
PDF version (31 KB)
I’m pleased to participate in this year’s Brimmer Policy Forum. Governor Brimmer and I did not overlap at the Board, but I admired his work from my perch at the Federal Reserve Bank of Kansas City, where I began my career in the System. And my colleagues at the Federal Reserve and I have benefited greatly since then from his analytical approach to difficult public policy issues. This morning I thought it might be useful for me to review the course of monetary policy through the crisis and highlight a few issues for policy in the future.
I’d like to make two important clarifications before I get started: First, despite the title of the Forum, what I am about to discuss is not President Obama’s monetary policy–it is the Federal Reserve’s. Fortunately, the Administration has been careful to respect the independence of the Federal Reserve in the conduct of monetary policy. It recognizes that the Federal Reserve’s insulation from short-term political pressures is essential for fostering achievement of its legislative objectives of stable prices and maximum employment over time. Second, the views you are about to hear are my own and not necessarily those of any other member of the Federal Open Market Committee (FOMC).
Monetary Policy Past
As a prelude to discussing where we are now and issues for the future, I thought it would be helpful to summarize the actions that we took over the past two years. In August 2007, we recognized that we were coping with a potentially serious disruption in financial markets that could feed back adversely on the economy and job creation. With liquidity in key funding markets drying up and some securitization markets closing down, lower policy interest rates alone were not going to be enough to keep financial conditions from tightening severely for households and businesses. In the end, we had to operate on multiple fronts to stabilize the financial markets and foster a rebound in the economy.
Expanding liquidity facilities. Our first actions were to ease the access of depository institutions to Federal Reserve liquidity. But, as the crisis worsened, it became apparent that these actions would be insufficient. Securities markets had come to play a prominent role in channeling credit in our economy, and severe disruptions outside the U.S. banking sector were threatening to reduce economic activity. To counter the financial shocks hitting the economy and support the flow of credit to households and businesses, we then needed to extend liquidity support to a range of nonbank institutions and to some financial markets. As we expanded the reach of our liquidity facilities, we generally followed the time-honored precepts of central bank behavior in a crisis: Extend credit freely to solvent institutions at a penalty rate against adequate collateral. By making liquidity available more broadly, we were trying to break the vicious spiral of uncertainty and fear feeding back on asset values and credit availability, and from there to the economy. We also found we needed to innovate by making liquidity available through auctions as well as standing facilities to overcome firms’ reluctance to borrow from the Federal Reserve out of concern that the borrowing could be inferred by market participants and viewed as an indication of financial weakness.
Lowering policy interest rates. In view of the likelihood that financial developments would lead to a weakening of aggregate demand, we began to lower the federal funds rate in September 2007, well before any hard evidence had become available regarding the magnitude of the restraint that it might impose on economic activity. As it became increasingly evident over the course of 2008 that the financial disruptions were sending the U.S. economy into recession, we picked up the pace of reductions in our federal funds rate target. Importantly, our ability to move aggressively was enhanced by an environment of already low inflation and stable inflation expectations.
Buying longer-term assets. To ease financial conditions further even after our policy interest rates had approached zero, we needed to operate directly on longer-term segments of the financial markets. Even though various types of debt securities are ordinarily quite substitutable, our purchases of agency-guaranteed mortgage-backed securities (MBS), agency debt, and Treasury securities evidently were successful in reducing long-term interest rates, partly because during the crisis, private-sector participants had a very marked preference for short-term assets.
Interest rate guidance. In this highly unusual situation, and with the normal response of monetary policy interest rates constrained by the zero lower bound, we consider it especially important that we convey as clearly as possible our policy intentions to market participants as they formulate their own expectations for the future path of interest rates. To help in this regard, we have noted in the statements we have released at the conclusion of each FOMC meeting our expectation that exceptionally low rates will likely be warranted for an extended period.
Inflation forecasts and objectives. Keeping inflation expectations anchored is always important but especially so in current circumstances, given the potential effects of the unprecedented economic developments and policy actions of the past two years on households’ and businesses’ views of the price outlook. To provide more information to the public about our own expectations and objectives, we have extended the horizon of the published projections of FOMC participants to five years and have supplemented these projections by reporting the long-term inflation rates Committee participants view as most consistent with satisfying our dual mandate.
Stabilizing systemically important institutions. In the absence of any other governmental agency having the authority to fill the role, we have lent to stabilize several systemically important institutions, any one of which–had it failed–would have posed a serious threat to the financial system and the economy. These actions, while necessary, were not well suited for a central bank, and we have urged the Congress to enact other means of safeguarding financial stability in such circumstances while imposing costs on shareholders, management, and, whenever possible, creditors.
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