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.

The sustainable or long-run trend growth rate of the economy is an important benchmark in calibrating the stance of monetary policy. In general, economies that grow faster exhibit real, or inflation-adjusted, interest rates that are somewhat higher than those of slow-growing economies. Monetary policymakers must be cognizant of that fact in setting the target for the fed funds rate. Failure to do so would likely result in the creation of either too much or too little liquidity, leading to too much or too little inflation or perhaps even deflation.

An “asymmetric policy tilt” seems appropriate given the risks to inflation.  However, the complexities of the current situation—including uncertainties concerning the behavior of output and employment, as well as growing downside risks to economic growth and the possibility that the neutral level of the funds rate has been lowered by a productivity slowdown—make it appropriate for policy to retain considerable flexibility in responding to emerging data.  The statement thus emphasizes that “Future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information.”  What all of these considerations add up to is that the stance of monetary policy will undoubtedly need to be adjusted in ways that are dictated by shifts in our forecasts for inflation, output, and employment in light of incoming data. 

An often overlooked implication is that, all else equal, an increase in the growth rate of productivity will tend to put upward pressure on real interest rates.  But in fact we have not seen the predicted rise in real rates.  Of course, we do not live in the world of simple economic models so all other things are not equal.  In particular, I believe one reason is that sound economic policies have created a more stable economic environment, and with that has come low and stable inflation and an ongoing desire by foreigners to invest in the United States to reap higher returns associated with higher productivity growth than may be available in their economies.        

In standard models, at a given real interest rate, a sustained increase in the growth rate of productivity should boost demand even more than it does potential supply in the long run. Or, to put the same thing another way--market interest rates eventually must rise after an upturn in productivity growth to equate demand and supply. The extra pressure on demand comes from several sources once the long-run growth of supply notches higher and is recognized by economic agents...In the short run, whether demand exceeds or falls short of potential supply and whether interest rates need to rise are ambiguous...This short-run ambiguity presents a challenge to monetary policy. Because of the lags in the response of the economy, policymakers must not only analyze the existing situation but also form a judgment about how demand and supply are likely to evolve over the next several years.