My objective today has been to review the evidence on the link between monetary policy in the early part of the past decade and the rapid rise in house prices that occurred at roughly the same time. The direct linkages, at least, are weak. Because monetary policy works with a lag, policymakers’ response to changes in inflation and other economic variables should depend on whether those changes are expected to be temporary or longer-lasting. When that point is taken into account, policy during that period–though certainly accommodative–does not appear to have been inappropriate, given the state of the economy and policymakers’ medium-term objectives. House prices began to rise in the late 1990s, and although the most rapid price increases occurred when short-term interest rates were at their lowest levels, the magnitude of house price gains seems too large to be readily explainable by the stance of monetary policy alone. Moreover, cross-country evidence shows no significant relationship between monetary policies and the pace of house price increases.
What policy implications should we draw? I noted earlier that the most important source of lower initial monthly payments, which allowed more people to enter the housing market and bid for properties, was not the general level of short-term interest rates, but the increasing use of more exotic types of mortgages and the associated decline of underwriting standards. That conclusion suggests that the best response to the housing bubble would have been regulatory, not monetary. Stronger regulation and supervision aimed at problems with underwriting practices and lenders’ risk management would have been a more effective and surgical approach to constraining the housing bubble than a general increase in interest rates. Moreover, regulators, supervisors, and the private sector could have more effectively addressed building risk concentrations and inadequate risk-management practices without necessarily having had to make a judgment about the sustainability of house price increases.
The Federal Reserve and other agencies did make efforts to address poor mortgage underwriting practices. In 2005, we worked with other banking regulators to develop guidance for banks on nontraditional mortgages, notably interest-only and option-ARM products. In March 2007, we issued interagency guidance on subprime lending, which was finalized in June. After a series of hearings that began in June 2006, we used authority granted us under the Truth in Lending Act to issue rules that apply to all high-cost mortgage lenders, not just banks. However, these efforts came too late or were insufficient to stop the decline in underwriting standards and effectively constrain the housing bubble.
The lesson I take from this experience is not that financial regulation and supervision are ineffective for controlling emerging risks, but that their execution must be better and smarter. The Federal Reserve is working not only to improve our ability to identify and correct problems in financial institutions, but also to move from an institution-by-institution supervisory approach to one that is attentive to the stability of the financial system as a whole. Toward that end, we are supplementing reviews of individual firms with comparative evaluations across firms and with analyses of the interactions among firms and markets. We have further strengthened our commitment to consumer protection. And we have strongly advocated financial regulatory reforms, such as the creation of a systemic risk council, that will reorient the country’s overall regulatory structure toward a more systemic approach. The crisis has shown us that indicators such as leverage and liquidity must be evaluated from a systemwide perspective as well as at the level of individual firms.
By my count, he gives three reasons that the decision at the time to maintain low interest rates from 2002 through 2004 made sense. First, the recovery was weak. Second, inflation, as measured by the deflator for Personal Consumption Expenditures, was low (it was revised up later). Third, and most important, the Fed forecast for inflation was low relative to temporary blips in inflation.
As I recall, mainstream macroeconomists were not screaming from the rooftops that monetary policy was too loose at the time. I tend to agree with Bernanke that the criticism of monetary policy seems post hoc and largely unwarranted.
I agree with his view that the housing bubble was caused much more by regulatory failure than monetary policy failure. But he says,
The lesson I take from this experience is not that financial regulation and supervision are ineffective for controlling emerging risks, but that their execution must be better and smarter.
In other words, we must not lose faith in technocratic control. We must execute technocratic control more effectively. At a fundamental level, this shows that he does not understand the discrepancy between knowledge and power that is the topic of Unchecked and Unbalanced. Unfortunately, the process for selecting Federal Reserve Board leaders selects only people who have an exaggerated view of the ability of expert technocrats to guide the economy.
James Kwak at Baseline Scenario:
I don’t really care about apologies. The more important question is what Bernanke and the Fed will do in the future. On that front, he has this to say:
“The Federal Reserve is working not only to improve our ability to identify and correct problems in financial institutions, but also to move from an institution-by-institution supervisory approach to one that is attentive to the stability of the financial system as a whole. Toward that end, we are supplementing reviews of individual firms with comparative evaluations across firms and with analyses of the interactions among firms and markets. We have further strengthened our commitment to consumer protection. And we have strongly advocated financial regulatory reforms, such as the creation of a systemic risk council, that will reorient the country’s overall regulatory structure toward a more systemic approach. The crisis has shown us that indicators such as leverage and liquidity must be evaluated from a systemwide perspective as well as at the level of individual firms.”
There are basically only two things in this paragraph, one of which is disingenuous at best. Bernanke claims that he is getting serious about consumer protection, yet he has lobbied against the Consumer Financial Protection Agency, which everyone who is serious about consumer protection wants. I’m disappointed that Bernanke would stoop to this kind of misleading rhetoric.
The other thing is a lot of talk about systemic risk. Yes, systemic risk is important. But all the words I hear about it, and the fact that the importance of systemic risk is one of the few things that everyone can agree on, are making me start to worry. Specifically, I wonder if a lot of regulatory apparatus aimed at systemic risk will serve as a distraction from old-fashioned regulation of individual institutions. Yes, it’s true that the thing that hit us in 2008 was systemic risk. But it’s also true that regulators already had the power to supervise Citigroup, Bank of America, Wachovia, Washington Mutual, Lehman Brothers, Bear Stearns, and Countrywide and force them to pare back their risky activities–and didn’t. Talking about systemic risk is a way of passing the buck–of excusing regulatory failure by saying that regulators didn’t have the authority to look at systemic risk. But the fact remains that someone looked at Citigroup’s range of businesses and its asset portfolio and decided it was a healthy bank.That was at least as big a problem.
I’ve been on the fence about Bernanke’s confirmation, mainly because I’m not so optimistic we’ll get anyone better from a policy standpoint, and we could certainly get someone worse from the standpoint of intelligence, knowledge, thoughtfulness, and work ethic. But now that I’ve read this speech, I’m against confirmation.
But it seems Bernanke left out a couple key points.
Bernanke used data from other countries to suggest monetary policy was not a huge contributor to the bubble … however, Bernanke didn’t discuss if non-traditional mortgage products contributed to housing bubbles in other countries. This would seem like a key missing part of the speech. Bernanke didn’t discuss how the current regulatory structure missed this “protracted deterioration in mortgage underwriting standards” (even though many people were pointing it out in real time). And Bernanke didn’t discuss specifically how the new regulatory structure would catch this deterioration in standards. How about some specific example of how the previous regulatory structure missed underwriting problems, and how the new structure would have caught the problem?I’m more interested in what Dr. Bernanke didn’t say.
But Bernanke should have been more forthright about the Fed’s undoubted failures: Greenspan’s rejection of advice about the risks of subprime lending, and the failure of top officials, BB included, to recognize the housing bubble in real time.
And I would add that focusing on unconventional mortgages is awfully 2007. We now know that many perfectly conventional mortgages went bust; we know that commercial real estate was at least as overblown as housing. Yes, you can argue that subprime helped inflate a general bubble; but it’s far from clear that it played a central role.
Where regulation really needs to focus is on making the financial system less fragile.
Dean Baker at The American Prospect:
The Fed is the country’s lead regulator. While the housing bubble was growing and bad mortgages were proliferating, Greenspan and the Fed insisted that everything was fine. Greenspan encouraged families to take out adjustable rate mortgages and did not even produce guidelines for mortgage issuance that banks had been expecting since the mid-90s. Greenspan and Bernanke also repeatedly disputed that there was anything out of the ordinary in the housing market, insisting that the run up in prices was driven by fundamentals.
Mr. Bernanke is absolutely right that low interests were not the cause of the housing bubble, but this hardly removes the Fed’s responsibility. While all the regulators share some of the blame, the bulk of the blame for bad regulation lies with the lead regulator, the Fed.
UPDATE: Barry Ritholtz
Dave at The League
UPDATE #2: David Leonhardt at NYT