Bernanke Says Low Rates Played Only Small Role in Housing Bubble

Fed Chairman Ben Bernanke, in a speech to the American Economic Association said that the low rate policy of the Fed in 2001-2004 played only a small role in the housing bubble. What were the culprits? Lax regulation, lax underwriting, exotic mortgage products and global capital flows.

In particular, he believes that up to 60% of the housing bubble was caused by exotic mortgage products and lax underwriting. This makes sense to me. In Boston, the housing market began to increase in 1998, before the Fed began raising rates. The rate of home price appreciation in the Northeast actually peaked in 2000, right before the tech bubble popped and when the Fed Funds rate was at 6%.

Almost anyone with a pulse could get a sizable mortgage. And the mortage products available made it possible to afford a very expensive home, or at least make it appear an expensive home was affordable. Interest-only loans, 1 year ARMs, etc. I remember my mortage broker telling me I wouldn't believe some of the deals he was writing. There was also no need to have a downpayment. Banks were doing 80-20 mortgages in which 80% of the houseprice was covered by an initial mortgage and 20% by a home equity loan. In many cases, individuals borrowed 110% of their home's value so that they could afford to renovate it and buy furniture.

Of course, low interest rates helped. They made the payments on ARMs that much lower during the initial period. But they were a contributor, not the proximate cause.

This all worked as long as housing prices kept going up. Once sky high oil prices popped the housing bubble, the whole system crashed.

Why This Is Important

So why is this important. Because Bernanke is defending the Fed against accusations that it is a cuase of asset bubbles. If you read between the lines you get the message that low rates alone are not a large contributor to asset bubble growth. And if that's the case, then the Fed is under no pressure to raise rates now.

Or as he says:

"Is there any role for monetary policy in addressing bubbles? Economists have pointed out the practical problems with using monetary policy to pop asset price bubbles, and many of these were illustrated by the recent episode. Although the house price bubble appears obvious in retrospect--all bubbles appear obvious in retrospect--in its earlier stages, economists differed considerably about whether the increase in house prices was sustainable; or, if it was a bubble, whether the bubble was national or confined to a few local markets. Monetary policy is also a blunt tool, and interest rate increases in 2003 or 2004 sufficient to constrain the bubble could have seriously weakened the economy at just the time when the recovery from the previous recession was becoming established."

So expect increased regulation and oversight over lending markets, but no rush to raise rates.