January 6, 2010

Taylor Disputes Bernanke on Bubble, Blaming Low Rates (Update1)

By Steve Matthews

Jan. 5 (Bloomberg) — John Taylor, creator of the so-called Taylor Rule for guiding monetary policy, disputed Federal Reserve Chairman Ben S. Bernanke’s argument that low interest rates didn’t cause the U.S. housing bubble.

“The evidence is overwhelming that those low interest rates were not only unusually low but they logically were a factor in the housing boom and therefore ultimately the bust,” Taylor, a Stanford University economist, said in an interview today in Atlanta.

Taylor, a former Treasury undersecretary, was responding to a speech by Bernanke two days ago, when he said the Fed’s monetary policy after the 2001 recession “appears to have been reasonably appropriate” and that better regulation would have been more effective than higher rates in curbing the boom.

Under former Chairman Alan Greenspan, the Fed lowered its benchmark rate to 1.75 percent from 6.5 percent in 2001 and cut it to 1 percent in June 2003. The central bank left the federal funds rate for overnight interbank lending at 1 percent for a year before raising it in quarter-point increments from 2004 to 2006.

“It had an effect on the housing boom and increased a lot of risk taking,” said Taylor, 63, who was attending the American Economic Association’s annual meeting.

Taylor echoed criticism of scholars including Dean Baker, co-director of the Center for Economic and Policy Research in Washington, who say the Fed helped inflate U.S. housing prices by keeping rates too low for too long. The collapse in housing prices led to the worst recession since the Great Depression and the loss of more than 7 million U.S. jobs.

Almost Zero

Bernanke and his fellow policy makers cut the benchmark interest rate almost to zero in December 2008 and have created unprecedented emergency credit programs to revive lending and spur a recovery.

The Fed chief, speaking at the same conference on Jan. 3, said increased use of variable-rate and interest-only mortgages, and the “associated decline of underwriting standards,” were more to blame for the price bubble than low interest rates.

Bernanke, 56, served as a Fed governor from 2002 until 2005 and backed all the interest-rate decisions under his predecessor, Alan Greenspan. Bernanke took over as Fed chairman in 2006 after serving for half a year as chairman of the White House Council of Economic Advisers.

“Low rates certainly contributed to the crisis,” Baker said in an interview on Jan. 3. “I don’t know how he can deny culpability. You brought the economy to the brink of a Great Depression.”

In his Jan. 3 speech, Bernanke used a modified form of the Taylor rule to support his argument that interest rates weren’t too low following the 2001 recession.

Inflation, Growth

The formula suggests how a central bank should set rates if inflation or growth veers from goals. While the standard rule uses existing data, Bernanke argued that policy makers instead should employ forecasts of prices and output.

Robert Hall, who heads the National Bureau of Economic Research’s panel that dates the beginning and end of recessions, said he found Bernanke’s argument convincing.

“I think Bernanke is completely correct,” Hall said.

Taylor said he didn’t agree with Bernanke’s “alternative interpretation” of his rule. Still, he said the rule supports the Fed’s current policy of keeping interest rates near zero.

“If we are fortunate to get a stronger recovery or if we are unfortunate and inflation picks up, the rate will have to rise,” he said.

–With assistance of Vivien Lou Chen in Atlanta. Editors: James Tyson, Christopher Wellisz

To contact the reporters on this story: Steve Matthews in Atlanta at +1-404-507-1310 or;


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