Addressing accusations that the Federal Reserve contributed to the financial crisis by keeping interest rates too low for too long in early 2000, helping to fuel a housing bubble, Fed Chairman Ben Bernanke argued in a speech to the American Economic Association that the interest rates set by the central bank between 2002 and 2006 were appropriately low and that regulatory, not monetary failure, was responsible for the housing bubble.
“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,” Mr. Bernanke said in his remarks.
The Fed Chief made the following 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.
As you can see [from Slide 1], 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”.
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. 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.”
Mr. Bernanke also argued in favor of raising interest rates to pop future asset bubble while emphasizing the necessity of strengthening the U.S. regulatory system.
“[If] adequate reforms are not made, or if they are made but prove insufficient to prevent dangerous build-ups of financial risks, we must remain open to using monetary policy as a supplementary tool”, Mr. Bernanke said. “[H]aving 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…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 policy-making as we feel our way forward”, he said.