A must read op-ed from John Taylor, the Stanford professor best known as the inventor of the famous Taylor Rule, rips apart Bernanke's recent defense of Fed policies in the 2002-2005 period, which claimed that the Fed was not responsible for the housing bubble. Bernanke, who pushed the blame for the bubble on indefinite interpretations of the implications of the Taylor Rule, and whose chairmanship of the Fed will be lost should he not be formally reconfirmed by the end of January, loses ever more credibility when considering Taylor's response that the Chairman "said that international evidence does not show a statistically significant relationship between policy deviations from the Taylor rule and housing booms. But his speech does not mention that research at the Organization for Economic Cooperation and Development in March 2008 did find a statistically significant relationship." Furthermore, Taylor blasts Bernanke's catch-all solution that new regulation will prevent such bubble in the future: "it is wishful thinking that some new and untried macro-prudential systemic risk regulation will prevent bubbles."
Taylor is not alone in his critique of the Fed Chairman, where he joins an ever increasing chorus laying the blame for asset bubbles squarely on the Fed's failed policy responses:
Many have expressed the view that monetary policy was too easy during [the 2002-2005] period. They include editorial writers in [the WSJ], former Fed policy makers such as Timothy Geithner (now the secretary of the Treasury), and academics such as business-cycle analyst Robert J. Gordon of Northwestern. But Mr. Bernanke focused most of his time on my research, especially on a well-known policy benchmark commonly known as the Taylor rule.
Yet what did the Taylor rule really state:
This rule calls for central banks to increase interest rates by a certain amount when price inflation rises and to decrease interest rates by a certain amount when the economy goes into a recession. My critique, which I presented at the annual Jackson Hole conference for central bankers in the summer of 2007, is based on the simple observation that the Fed's target for the federal-funds interest rate was well below what the Taylor rule would call for in 2002-2005. By this measure the interest rate was too low for too long, reducing borrowing costs and accelerating the housing boom. The deviation from the Taylor rule, which had characterized good monetary policy during the previous two decades, was the largest since the turbulent 1970s.
The primary variation in Taylor rule readings: the usage of actual versus expected inflation rates:
[Bernanke] put the Fed's forecasts of future inflation into the Taylor rule rather than actual measured inflation. Because the Fed's inflation forecasts were lower than current inflation during this period, this alternative obviously gives a lower target interest rate and seems to justify the Fed's decisions at the time.
There are several problems with this procedure. First, the Fed's forecasts of inflation were too low. Inflation increased rather than decreased in 2002-2005. Second, as shown by economists Athanasios Orphanides and Volker Wieland, who previously served on the Federal Reserve Board staff, if one uses the average of private sector inflation forecasts rather than the Fed's forecasts, the interest rate would still have been judged as too low for too long.
Third, Mr. Bernanke cites no empirical evidence that his alternative to the Taylor rule improves central-bank performance. He mentions that forecasts avoid overreacting to temporary movements in inflation—but so does the simple averaging of broad price indices as in the Taylor rule. Indeed, his alternative is not well defined because one does not know whose forecasts to use. Moreover, the appropriate response to an increase in actual inflation would be different from the appropriate response to an increase in forecast inflation.
Bernanke's defense of the Fed is immediately put into question considering the evidence that he had brought up:
Mr. Bernanke claimed that "Economists who have investigated the issue have generally found that, based on historical relationships, only a small portion of the increase in house prices earlier this decade can be attributed to the stance of U.S. monetary policy." But two of the economists he cites—Frank Smets, director of research at the European Central Bank, and his colleague Marek Jarocinski—reported in the July/August issue of the St. Louis Fed Review that "evidence that monetary policy has significant effects on housing investment and house prices and that easy monetary policy designed to stave off perceived risks of deflation in 2002-04 has contributed to the boom in the housing market in 2004 and 2005."
In essence, courtesy of a flawed and consistent misreading of real interest rates, the Fed did everything to subsidize a cost of capital to borrowers that made it extremely attractive to take on ever increasing amounts of debt, and for which the Fed' monetary policy is all to blame:
You do not have to rely on the Taylor rule to see that monetary policy was too loose. The real interest rate during this period was persistently less than zero, thereby subsidizing borrowers. Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, reported in a speech on Jan. 7 that during the past decade "real interest rates—the nominal interest rate adjusted for inflation—remained at negative levels for approximately 40 percent of the time. The last time this occurred was during the 1970s, preceding a time of turbulence."
The inability of the Fed to accept blame for its misguided policy is very troubling to Taylor:
Not admitting the possibility raises concerns. One is that if such a large deviation from standard policy is rationalized away, it might happen again. Indeed, some analysts are worried now about the Fed holding interest rates too low for too long, causing another boom-bust and a shorter expansion.
Bingo. Yet happily the Fed continues focusing on core CPI, which sets the stage for yet another round of blame games in a several years, together with the daily televised circus from Congress and the Senate.
Another concern is that, rather than trying to be vigilant and avoid causing bubbles, the Fed will try to burst them with interest rates. Indeed, one of the lines from Mr. Bernanke's speech most picked up by Fed watchers is that "we must remain open to using monetary policy as a supplementary tool for addressing those risks." We have very limited ability to fine tune monetary policy in such an interventionist way.
Finally, there is a concern that the line of analysis in Mr. Bernanke's speech puts the full burden of preventing future bubbles on new regulation. Clearly the Fed missed excessive risks on and off the balance sheets of the banks that it supervises and regulates. That policy needs to be corrected. However, it is wishful thinking that some new and untried macro-prudential systemic risk regulation will prevent bubbles.
In conclusion, Taylor disagrees entirely with the Fed proposed approach to dealing with the current and future bubbles, and advocates full "transparency" in evaluating just what the proper resolution to the Fed's unmitigated failure should be. Of course, for that to happen, the Fed will need to be subject to far greater transparency than it allows currently.
While I disagree with Mr. Bernanke's analysis, it is good news that the Federal Reserve Board has begun to examine its policies and publish its findings. This will help inform the Financial Crisis Inquiry Commission, which will soon begin holding public hearings on the causes of the financial and economic crisis. In the meantime I hope the Federal Reserve Board will continue with this new self-examination policy and transparently evaluate all its recent crisis-related actions, from the AIG bailout to the Mortgage Backed Security purchase program.
We hope more honest, and not those conflicted beyond repair and on the Fed's payroll economists speak out against the travesty that is the combination of flawed Fed monetary policy and a limited array of resolving incipient asset bubbles. Alas, as we already are in precisely such a bubble currently, proactive efforts of dealing with what will inevitably result in yet another crisis likely need to focus more on the clean up operations than on any prophylactic intervention. Unfortunately, it is by now too late to do the latter.