FILE - In this July 22, 2009 photo, Federal Reserve Chairman Ben Bernanke testifies on Capitol Hill in Washington. The Federal Reserve on Monday, Dec. 28, 2009, proposed allowing banks to set up the equivalent of certificates of deposit at the central bank, a move aimed at helping the Fed reel in an unprecedented amount of money plowed into the economy during the financial crisis. (AP Photo/Gerald Herbert, file) (Gerald Herbert - AP)

Washington Post Staff Writer
Monday, January 4, 2010

Better regulation is the key to avoiding future financial excesses, Federal Reserve Chairman Ben S. Bernanke said Sunday, arguing that the Fed’s low-interest-rate policies early in the decade were not a major cause of the housing bubble.

Bernanke did suggest, however, that he is open to using monetary policy — the power to expand or contract the money supply by adjusting interest rates — to combat future bubbles, but would do so only if regulatory policy did not contain financial risks. His comments, before the American Economic Association, reflect efforts by economists at the Fed and beyond to assess the lessons from the financial crisis and recession of the past two years.

“Having experienced the danger that asset bubbles can cause, we must be especially vigilant in ensuring that the recent experiences are not repeated,” Bernanke said in Atlanta, according to a published text.

He added that if the regulatory system isn’t reformed to deal with future bubbles or if it cannot keep risks in check, “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.”

The difficulties he has in mind: It can be hard to know for sure when a bubble is underway — many economists argued that high home prices earlier in this decade were justified, for example. Also, interest rate increases to combat bubbles are a blunt instrument and can drag down the entire economy.

Bernanke, as a Fed governor, was an advocate of the decision to cut the Fed’s target interest rate to 1 percent in 2003, leave it there for a year and raise it only slowly thereafter

Some economists — and lawmakers — have assailed the Fed for keeping rates low through that period. They say low rates resulted in cash gushing through the economy, some of which went to bidding up the prices of houses and other assets beyond levels justified by their fundamentals.

“While keeping interest rates low for a protracted period of time, the Fed seemed remarkably unconcerned about the possibility of igniting a different financial crisis by inflating a housing price bubble,” said Sen. Richard C. Shelby (R-Ala.) in a Senate Banking Committee session last month.

That was one reason, he said, he voted against moving Bernanke’s nomination for a second term to the full Senate.

On Sunday, speaking at the annual meeting of the major association for academic economists, Bernanke laid out a case that the interest rate policy was, at best, a modest contributor to the over-inflation of home prices.

He also assigned primary blame for the housing bubble to relaxed lending standards and views among Americans — consumers and bankers alike — that housing prices would rise forever.

“At some point, both lenders and borrowers became convinced that house prices would only go up,” Bernanke said. “Borrowers chose, and were extended, mortgages that they could not be expected to service in the longer term. They were provided these loans on the expectation that accumulating home equity would soon allow refinancing into more sustainable mortgages. For a time, rising house prices became a self-fulfilling prophecy, but ultimately, further appreciation could not be sustained, and house prices collapsed.”

He argued that bank supervisors and other financial regulators, of which the Fed is one, would have had a better ability to contain the excesses that led to the current crisis than the Fed in its role as monetary-policy maker.

Also speaking at the conference, Fed Vice Chairman Donald L. Kohn discussed the more immediate task for the Fed, deciding how and when to remove its extraordinary efforts to support the economy for the past two years.

He forecast a weak recovery and said conditions are likely to warrant “exceptionally low” interest rates “for an extended period” — repeating language Fed leaders have been using for more than a year.

But he also stressed that the Fed has the tools it will need to raise interest rates and shrink the money supply when the time comes.

And he pledged that the central bank will operate independently from short-term political concerns and not, in effect, finance government budget deficits by printing money or allowing high inflation to develop.

“A large and growing federal deficit will not stop the Federal Reserve from exiting from current policies when that’s needed to keep prices stable and the economy on a path to sustained high employment,” Kohn said.