Bernanke defends Fed’s monetary policy pre-crisis

Though this speech (pdf version has all charts) of Bernanke has been talked about everywhere. I thought I should still post on it in case some have not still read it. It is a must read.

In this speech, Bernanke discusses the oft-repeated criticism that Fed kept interest rates low in 2001-07 and then raised them very slowly, that led to the build up of the housing bubble and the huge crisis followed.

He says both the criticisms are not really right.

  • Were low rates appropriate? John Taylor first brought the criticism on Fed in his 2007 Kansas Fed Symposium paper. He said  Fed interest rates were lower when compared to the rates that should be according to Taylor rules. Bernanke discusses Taylor rules in details (excellent explanation) and says Taylor’s version is based on current inflation/output levels. As monetary policy works with a lag we should instead use forecast values. When we use forecast values, we get the fed funds rate closer to what Fed actually did. So, given the macro conditions, the low rates are justified.
  • Did low rates lead to housing bubble? He points to a recent research model. As per the model, house prices increased much higher with low fed funds rate and other fundamentals.  He then looks at whether innovations in housing finance that promised low interest rates now and adjustments later. He says again monetary policy tightening would have led to a marginal hike in interest rates and would have not kept people away from the housing sector.

He also looks at international evidence on link between monetary policy and housing sector:

Let me turn now to the international evidence on the link between monetary policy and house price appreciation. Some cross-country evidence on this link is shown in slide 9. The figure is drawn from a recent study of 20 industrial countries by the International Monetary Fund (IMF) (Fatás and others, 2009) and replicated by Board staff.

As Slide 9 shows, the relationship between the stance of monetary policy and house price appreciation across countries is quite weak. For example, 11 of the 20 countries in the sample had both tighter monetary policies, relative to the standard Taylor-rule prescriptions, and greater house price appreciation than the United States. The overall relationship between house prices and monetary policy, shown by the solid line, has the expected slope (tighter policy is associated with somewhat slower house price appreciation). However, the relationship is statistically insignificant and economically weak; moreover, monetary policy differences explain only about 5 percent of the variability in house price appreciation across countries.

He adds what explains the rise in housing prices is not mon policy but capital inflows:

What does explain the variability in house price appreciation across countries? In previous remarks I have pointed out that capital inflows from emerging markets to industrial countries can help to explain asset price appreciation and low long-term real interest rates in the countries receiving the funds–the so-called global savings glut hypothesis (Bernanke, 2005, 2007). Today is not the appropriate time to revisit that hypothesis in any detail, but I would like to take a moment to show that accounting for capital inflows is likely to prove fruitful for explaining cross-country differences.

Slide 10, which is analogous to Slide 9, shows the relationship between capital inflows and house price appreciation for the same set of countries as in the previous slide. Also as in the previous slide, house price appreciation is shown on the vertical axis of the figure. The horizontal axis shows the increase in the current account (equivalently, the increase in capital inflows) for each country, measured as a percentage of GDP. The downward slope of the relationship is as expected–countries in which current accounts worsened and capital inflows rose (shown in the left half of the figure) had greater house price appreciation over this period. However, in contrast to the previous slide, the relationship is highly significant, both statistically and economically, and about 31percent of the variability in house price appreciation across countries is explained.

This simple relationship requires more interpretation before any strong conclusions about causality can be drawn; in particular, we need to understand better why some countries drew stronger capital inflows than others. I will only note here that, as more accommodative monetary policies generally reduce capital inflows, this relationship appears to be inconsistent with the existence of a strong link between monetary policy and house price appreciation.


So where does the blame lie? Well on weak financial regulation and supervision as Bernanke has always specified in his previous speeches.

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.

In the end he says, if adequate financial regulation reforms are not made then monetary policy could be tried

That said, having experienced the damage that asset price bubbles can cause, we must be especially vigilant in ensuring that the recent experiences are not repeated. All efforts should be made to strengthen our regulatory system to prevent a recurrence of the crisis, and to cushion the effects if another crisis occurs. However, if adequate reforms are not made, or if they are made but prove insufficient to prevent dangerous buildups of financial risks, we must remain open to using monetary policy as a supplementary tool for addressing those risks–proceeding cautiously and always keeping in mind the inherent difficulties of that approach. Clearly, we still have much to learn about how best to make monetary policy and to meet threats to financial stability in this new era. Maintaining flexibility and an open mind will be essential for successful policymaking as we feel our way forward

This is quite a change. So we have Bernanke finally agreeing that monetary policy should step in for bubbles. Though he remains silent on what should the central bank do in such situations.

A useful speech as it gives a good explanation of so many things on monetary economics. A typical speech which Bernanke used to give before the crisis – full of references and literary stuff. After crisis, his speeches are more of the outlook, Fed responses to the crisis  variety which are monotonous.

The content of the speech will always be debated and many papers would follow in future. But yes, it is nice to see Bernanke agreeing that financial bubbles is a serious problem.

6 Responses to “Bernanke defends Fed’s monetary policy pre-crisis”

  1. John Taylor responds to Ben Bernanke « Mostly Economics Says:

    […] Taylor responds to Ben Bernanke By Amol Agrawal Bernanke had recently defended Fed’s loose monetary policy before the crisis. He mainly looked at Taylor rules and […]

  2. Benefits and Limitations of Taylor rule « Mostly Economics Says:

    […] He then looks at these limitations and applies it on policy real time.  He shows how applying the Taylor rules in real time leads to difficulties. Pretty much what Bernanke said in his recent speech. […]

  3. Florentino Belt Says:

    Outstanding posting. I appreciate you for posting it. Keep up the great blogging.

  4. Bernanke’s 4 lessons from history of economic policy « Mostly Economics Says:

    […] repetitive and not very exciting. This one was small but still had some great insights. Another good recent speech from Bernanke was review of Fed policy before the […]

  5. Mostly Economics: Bernanke’s 4 lessons from history of economic policy : Livemint Blogs Says:

    […] repetitive and not very exciting. This one was small but still had some great insights. Another good recent speech from Bernanke was review of Fed policy before the crisis. Filed under: Academic research & […]

  6. Ben Bernanke vs John Taylor …again « Mostly Economics Says:

    […] (see this) that Fed kept policy rates much lower in 2003-06 than what his Taylor rule predicted. Bernanke (and Kohn) gave a stirring speech saying Taylor rule does not work in real-time policy.  Taylor […]

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