Between August 2002 and January 2005- two-and-a-half years- the federal funds rate was below the rate of core inflation.  Such low interest rates encourage borrowing and a buildup of debt, sometimes in ways we do not fully appreciate until much later with the benefit of hindsight.  In addition, low interest rates- especially with a commitment to keep them low- led banks and investpors to feel "safe" in the search for yield, which involves investing in less-liquid and more risky assets.  In addition, financial institutions often search for yield by increasing the amount of assets supported by each dollar of net worth- leverage.  For example, leverage at securities broker dealers rose dramatically.  After averaging just 13 1/4 between 1970 and 2000, leverage climbed to a high of 40 in the third quarter of 2007- the start of the financial crisis.

It was after a period of too-low interest rates, too much credit, too much leverage that the collapse of the housing bubble, the rapid deleveraging and the ensuing financial crisis occurred.  And it was after these events that unemployment rose to more than 10 percent and the United States lost 8.4 million jobs.  In 2010, we have only gained back 573,000 jobs.

Now, let me be clear: I do not believe the Fed to be blameless in the run-up to the crisis we are now working our way out of. For quite some time, I have respectfully differed with Chairman Bernanke, saying that I felt the Fed held interest rates too low for too long in the early half of the 2000s, thus fueling reckless speculation in housing and other sectors. And I have freely admitted that a host of regulators, including those at the Federal Reserve, were caught unawares by the risk being taken by large financial institutions that later came a cropper.

Low rates also interfere with the economy’s ability to allocate resources and distort longer-term saving and investment decisions. Artificially low rates discourage saving and subsidize borrowers at the expense of savers. Over the past decade, we channeled too many resources into residential construction and financial activities. During this period, real interest rates—nominal rates 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. Low interest rates contributed to excesses. It would be a serious mistake to attempt to grow our way out of the current crisis by sowing the seeds for the next crisis.

Many people say that the Fed kept interests rates too low for too long in the early part of this decade. During that period, I would have liked to have raised interest rates sooner. When we did raise interest rates, we raised them in a lockstep fashion. I don’t think there is any theory that told you that was the right thing to do.

Looking back on the crisis thus far, however, I believe that a strong case can be made that the financial safety net, especially those parts that were more implicit and perceived than explicit and written into the laws, played a significant role in the accumulation of risks that ultimately led to the turmoil we are still experiencing. While deployment of the financial safety net is often viewed as an essential response to the financial crisis, I believe we need to give serious thought to the extent to which the safety net was actually a significant cause of the crisis.

In my view, the rush to respond has had negative consequences...Without a systematic plan for addressing the crisis, policy actions have been ad hoc, resulting in inequitable outcomes among firms, creditors and investors that have increased uncertainty and undermined confidence.  Nowhere is this more apparent than in the treatment of large, complex financial institutions that have been labeled as "systemically important" and "too big to fail."

This crisis began, not in September, but it began back in early '07. And I was at the center of efforts to try to promote a much more aggressive response early, not just on the housing side but through -- but in the financial sector in particular. And I was very involved in trying to make sure that the central bank, in particular, was moving aggressively to make sure that monetary policy was getting to a better place where it could support recovery and that we were encouraging banks to raise capital necessary it play a critical role in recovery.

And I did work very actively to try to encourage the administration to get the broader authorities that we thought were going to be necessary to address this. But this did not begin last September. It began well before that. And although policy did move, it did not move aggressively enough across the entire board. And we're living with the consequences of a deeper recession, in part, because of that.

In response to a question from Sen. Blanche Lincoln

The turmoil intensified in mid-September, and volatility has been elevated since. Financial market participants have faced three major categories of uncertainty. The first concerns the aggregate amount of losses on mortgage lending...

Second, financial market participants have faced uncertainty about where the losses will turn up...

Third, market participants have at times faced uncertainty about prospective public sector intervention.⁴ The disparate responses to potential failures at several high-profile organizations may have made it difficult for market participants to forecast whether official support would be forthcoming for a given counterparty. Shifts in expectations regarding official intervention may have added volatility to financial asset markets that already were roiled by an increasingly uncertain growth outlook. And uncertainty about the form of government support — asset purchases versus dilutive capital purchases, for example — may have hindered the provision of fresh equity capital.

The proximate cause of the financial market turbulence, of course, is the home mortgages made from late 2005 through early 2007, near the end of long U.S. housing boom that began in 1995...

It will take years of research to untangle the quantitative contribution of various causal factors to the decade-long housing boom, the accompanying rise in subprime mortgage lending, and the subsequent increase in mortgage losses. A definitive assessment is too much to ask at this point, but a list of the most plausible suspects can easily be discerned. One candidate that is often overlooked is the significant increase in productivity growth, and thus growth in real household income, which began around 1995 and lasted until some time earlier in this decade...

Another plausible contributing factor was the wave of technological innovation in retail credit delivery, which allowed lenders to make finer distinctions between potential borrowers. This facilitated lower interest rates for some borrowers and an expansion of lending to borrowers formerly viewed as unqualified for credit...

The regulatory and supervisory regime surrounding U.S. housing finance also seems likely to have contributed to the boom in housing and housing finance. Here, several factors deserve mention...

Another key causal suspect is the relatively low path of interest rates after the recession earlier this decade, especially in 2003 and 2004. Some economists have argued, with the benefit of hindsight, that tighter monetary policy during that period would have led to better outcomes by preventing core inflation from rising, thus limiting the housing boom and mitigating the subsequent bust. This view strikes me as quite plausible, but again, further research will be required to substantiate this hypothesis.

Although the early attempts to staunch the recession were well-intentioned, it will be a subject of debate for some time on whether the rush to action might have contributed to the worsening of conditions.

A good central banker knows how costly imperfect data can be for the economy. This is especially true of inflation data. In late 2002 and early 2003, for example, core PCE measurements were indicating inflation rates that were crossing below the 1 percent "lower boundary." At the time, the economy was expanding in fits and starts. Given the incidence of negative shocks during the prior two years, the Fed was worried about the economy's ability to withstand another one. Determined to get growth going in this potentially deflationary environment, the FOMC adopted an easy policy and promised to keep rates low. A couple of years later, however, after the inflation numbers had undergone a few revisions, we learned that inflation had actually been a half point higher than first thought.

In retrospect, the real fed funds rate turned out to be lower than what was deemed appropriate at the time and was held lower longer that it should have been. In this case, poor data led to a policy action that amplified speculative activity in the housing and other markets. Today, as anybody not from the former planet of Pluto knows, the housing market is undergoing a substantial correction and inflicting real costs to millions of homeowners across the country. It is complicating the task of achieving our monetary objective of creating the conditions for sustainable non-inflationary growth.