Federal Reserve Chairman Ben Bernanke Thursday pushed back against critics who lay much of the blame for the recent financial crisis on the monetary policies of the Fed.
Testifying before the Financial Crisis Inquiry Commission, Bernanke questioned the assertion made by some that the monetary policy of low interest rates set by the Fed significantly contributed to the housing bubble.
Bernanke acknowledged that the Fed did cut interest rates to a "very low level" during and following the 2001 recession in response to a sluggish labor market and the threat of deflation.
"Those actions were in accord with the FOMC's mandate from the Congress to promote maximum employment and price stability," he said. "Indeed, the labor market recovered from that episode and price stability was maintained."
But, Bernanke said there was little evidence that the low interest rates played much of a role in the housing market.
"It is frankly quite difficult to determine the causes of booms and busts in asset prices," he said. "Studies of the empirical linkage between monetary policy and house prices have generally found that that linkage is much weaker than would be needed to explain the behavior of house prices in terms of [Fed] policies during this period."
Furthermore, Bernanke said, other countries experienced similar housing bubbles despite having very different monetary and interest rate policies.
"Even though some countries other than the United States had substantial booms in house prices, there was little correlation across industrial countries between measures of monetary tightness or ease and changes in house prices," he said. "For example, the United Kingdom also experienced a major boom and bust in house prices during the 2000s, but the Bank of England's policy rate went below 4 percent for only a few months in 2003."
The more consistent evidence, Bernanke said, suggests that the bubble was caused by a "feedback loop" caused by optimism about ever-increasing housing prices and financial instruments that were theoretically designed to shield investors from risk.
"Rising prices in turn further fueled optimism about the housing market and further increased the willingness of lenders to further weaken mortgage terms," he said. "Importantly, innovations in mortgage lending and the easing of standards had far greater effects on borrowers' monthly payments and housing affordability than did changes in monetary policy."
Bernanke also rejected the contention that the Fed could have acted to stop or slow the inflation of the housing bubble by increasing interest rates earlier.
"For several reasons, this was not a practical policy option," Bernanke said. "First, in 2003 or so, when the policy rate was at its lowest level, there was little agreement about whether the increase in housing prices was a bubble or not."
He added, "Second, and more important, monetary policy is a blunt tool; raising the general level of interest rates to manage a single asset price would undoubtedly have had large side effects on other assets and sectors of the economy."
Furthermore, Bernanke said, in order to have had much effect, the Fed would likely have had to raise rates quite sharply, something he said would have been unwise during a jobless recovery faced with the risk of deflation.
"Generally, financial regulation and supervision, rather than monetary policy, provide more-targeted tools for addressing credit-related problems," he said. "Enhancing financial stability through regulation and supervision leaves monetary policy free to focus on stability in growth and inflation, for which it is better suited."
He added, "We should not categorically rule out using monetary policy to address financial imbalances, given the damage that they can cause. … However, whenever possible, supervision and regulation should be the first line of defense against potential threats to financial stability."
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