The Fed is loath to admit accommodative monetary policy contributed to the financial crisis. In his testimony before the Financial Crisis Inquiry Commission in September, Federal Reserve chairman Ben Bernanke pointed to several factors he believes caused or contributed to the recent global financial crisis. Among “vulnerabilities” in the private sector, Bernanke listed maturity and currency mismatches in the shadow banking system, inadequate risk management, excessive financial leverage, and inappropriate use of derivatives. He discussed similar shortfalls among government regulation and regulators, but explicitly excluded monetary policy from that list. The perfect-storm severity makes it plausible several factors caused the crisis. But the same consideration may make Bernanke’s reluctance to concede monetary policy had anything to do with events less than persuasive. In denying that the Fed’s unusually accommodative monetary policy following the 2001 recession played a role, Bernanke defined the crisis narrowly, arguing monetary policy did not cause the housing bubble. On that point, Bernanke may well be correct. As discussed in an earlier column, interest rates on both 30-year fixed and one-year adjustable rate mortgages did not drop nearly as much as the short-term interbank borrowing rate the Fed brought down all the way to 1% in 2003–04 (see Credit, April 2010, p. 16). Furthermore, the origins of the housing bubble arguably go back well before the Fed’s actions in 2003–04. After the bursting of the equities bubble in early 2000, people were hesitant to invest in financial assets, preferring to put their savings in real assets, such as houses. Additionally, after the 9/11 terrorist attacks, the US for a while experienced a cocooning effect: many Americans were reluctant to fly to vacation destinations, preferring to spend discretionary dollars on anything related to their homes. The bubble in housing prices was arguably not a cause but a symptom of a much wider phenomenon. The prosperity of much of the last decade was not built so much on a housing bubble as it was on a credit bubble instead. Two things that happened over the past decade are worth noting. First, is the explosive growth of the shadow banking system. A New York Federal Reserve report published in July estimates that by March 2008, liabilities in the shadow banking system were nearly $20 trillion, far exceeding liabilities in the traditional banking system. Prior to the crisis, the shadow banking system did not fall within the Fed’s primary scope of monitoring activities, because it operated outside the traditional banking channel of depository institutions that are subject to Fed oversight. No shadow of doubt But monetary policy clearly did affect the shadow banking system, as shadow banks tend to borrow short term while lending long, using a large amount of financial leverage. The Fed report concluded the shadow banking system “contributed significantly to asset bubbles in residential and commercial real estate markets prior to the financial crisis”. The other factor is the global saving glut, identified by Bernanke in March 2005. Foreign capital inflows into the US in the mid-2000s led to lower long-term nominal risk-free interest rates than would otherwise have been the case. The combination of ultra-low short-term borrowing costs and low long-term rates led to a search for yield and an underpricing of risk. It was not so much that low short-term interest rates resulted in low mortgage rates and thereby an inflated demand for housing. Rather, it was that low short-term interest rates enabled the financing of risky assets, including mortgage-related securities, at unsustainably cheap levels. If the Fed had not kept short-term rates as low for as long as it did, it might not have changed long-term rates that much, but it would likely have decreased the debt-financed trading activity by the shadow banking system that caused asset-price inflation. With the benefit of hindsight, the Fed should have “leaned against the wind” of foreign capital inflows into the US, by tightening monetary policy earlier and more quickly than it did. Arguably, the Fed’s was a sin of omission rather than commission – but a sin no less. Jerry Tempelman is a director with the capital markets research group at Moody’s Analytics. He was previously a senior financial and economic analyst with the Federal Reserve Bank of New York. The views expressed are strictly his own....
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