The Blame Game Surrounding the Fed

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In a Sunday speech at the American Economic Association annual meeting, Federal Reserve Chairman Ben Bernanke explained that monetary policy did not cause the housing price bubble or the resulting financial crisis.  He asserted (again) that global imbalances were a critical factor in creating asset-price appreciation and low long-term real interest rates.  According to this theory, the “savings glut” (largely driven by China and the Gulf states) was recycled into U.S. Treasury securities and the debt of other developed countries, which then kept longer-term interest rates down and fueled an international housing price bubble.  While global imbalances were certainly a factor, it is unfortunate that Bernanke did not acknowledge, at least broadly, that the Fed’s loose monetary policy (earlier in the decade) contributed to the financial crisis.  Not making this concession only aids the Fed’s opponents, like Representative Ron Paul, and others who threaten the central bank’s independence.  

There is little in conventional economic analysis to suggest that Fed policy, which sets short-term (overnight) lending rates, should have much of an impact on housing prices, which are financed through longer-term borrowing.  At the Fed’s 2007 Jackson Hole Conference, then-Fed Governor Ric Mishkin provided a summary of research on monetary policy’s impact on housing.  Although Mishkin generally endorsed the view that only long-term rates matter for mortgage finance, he noted the role that adjustable rate mortgages (ARMs) resets could play in reducing household cash flow.  ARMs are tied to short-term rates.  As those rates increase, the rise in mortgage payments reduces household cash flow, which, in turn, can reduce housing demand and push prices down.  But, as Bernanke noted in his speech, ARMs were not a sufficiently large portion of the mortgage finance market to have had such a large impact on house prices.  Furthermore, it seems that housing prices became untethered from economic fundamentals anyway; both Bernanke and Mishkin seem to believe that irrational expectations of housing price dynamics (“housing prices will never fall”) explain much of the bubble.  

These analyses, however, fail to account for the impact Fed policy has on the balance sheets of financial intermediaries.  Investment banks and broker dealers finance much of their holdings on a short-term basis, as the world found out painfully in 2008, through the repo and commercial paper funding markets.  Short-term rates set by the Fed directly influence these institutions’ borrowing costs.  As the borrowing costs go down, it becomes more profitable to finance more assets, which causes their balance sheets to expand and more credit to be extended to borrowers.  

A 2009 article in the American Economic Review explains how overly-easy monetary policy causes credit supplied through this “market-based lending” channel to explode.  By lowering short-term interest rates to 1%, the Fed made it very profitable for investment banks to expand their balance sheets.  The AER article found that this asset growth at investment banks explains changes in housing investment, after controlling for other relevant variables.  By the end of 2007, the credit supplied by investment banks and securitization accounted for twice as much of the value of outstanding home mortgages as traditional bank finance.  Had the Fed recognized the impact of low rates on balance sheet growth at investment banks (and the subsequent impact that growth was having on housing investment), and then raised short-term rates more rapidly, the severe impact of the crisis might have been softened.

A number of factors converged to unleash the financial crisis.  The Fed’s monetary policy wasn’t the most important factor, but it clearly contributed to the dramatic asset price boom and bust cycles of the past decade.  Central bankers need to pay closer attention to short-term interest rates and how they incentivize financial intermediaries to exploit differences in rates-of-return and add aggressively to their balance sheets.  Not appreciating these dynamics sufficiently and opting instead for defensive (and highly technical) speeches, will only strengthen the hand of people like Rep. Paul and others in Congress who wish to stifle the independence of the Federal Reserve.  And a politicized Fed – the inevitable outcome of less independence – will threaten the Fed’s effectiveness and, by extension, the health of the U.S. economy in the long-term.