Taken together, the economic data generally point to an economy that is moving in the right direction and has consistently sustained growth over the past five years. This is not to say the economy is issue-free… Unfortunately, although we might wish it so, monetary policy is not the proper tool to address all of these issues. The aggressive monetary actions over the past few years were intended to support economic activity, help labor markets heal and move inflation toward the Fed’s target. I view the considerable progress in labor markets and the relatively steady inflation rate as encouraging. However, keeping interest rates near zero to achieve still further progress toward labor market improvement and higher inflation is risky in my view. In a protracted period of exceptionally low rates, investors seeking out higher returns are willing to take on more risk or seek out more creative financing approaches. When the economy is expanding and rates remain low, adverse events may appear less likely or far into the future, potentially resulting in the mispricing of risk and financial assets. Waiting too long to adjust rates, as we’ve seen in the past, can leave policymakers with few and possibly poor options. … The FOMC has been talking about its exit strategy since 2011. And since March of this year, the Committee has been emphasizing that a decision to raise interest rates would be data dependent. In other words, economic data that confirms further gains in the economy’s performance will drive the timing of the Committee’s actions. So, why hasn’t the FOMC yet raised rates? There are of course different views on the economic data we receive and analyze that lead to legitimate, differing views about what is best for the economy… The continued improvement in the labor market, combined with low and stable inflation, convince me that modestly higher short-term interest rates are appropriate. Current guideposts, or “policy rules,” often used to inform monetary policy decisions also have been signaling that interest rates should be higher. I recognize that a rate increase, however, would be the first one in nearly a decade. So I am not suggesting rates should be normalized quickly or that policy should be tight. Although the economy has improved, economic fundamentals could well mean an accommodative stance of policy is appropriate for some time. I would like to avoid the cost of waiting for more evidence and further postponing liftoff, drawing on a valuable lesson from monetary policy decisions in 2003.

Actually, what {Dudley} said in footnote five of that speech was that you could make a case that the Fed should have moved faster. That’s what he said, he didn’t sort of say that it was a mistake.

Interesting question. I frankly think anyone who says the way we did things before the crisis, we probably should have done them differently, you’re going to get a hearing on any -- any idea of that, that sounds like that. And this is one of those, it’s absolutely worthwhile look at that.

I -- so the real question is, would that have made a -- if the Fed had moved, you know, in a less measured way, measured pace, would that have made a big difference in the financial crisis? And I think the answer is clearly no.

You know, you had a -- you had a housing bubble that was kind of self-contained, it was kind of expectations of market participants, buyers and sellers that housing was always going to go up, up, up, up, there’s no such thing as housing prices going down. You had a bubble, and that happened.

I think the mistakes that were made before the crisis, were much more about regulation, supervision, and really, just imagination. You know, no one thought -- very few people saw this coming. Very few people thought this was coming.

You know, conceivably, I think, with the benefit of hindsight, it might have been better to raise rates more rapidly or more during the 2004-06 cycle. I'm -- you know, I'm not certain of that judgment, but I think there's a case to be made.

With the benefit of hindsight, one could argue that the Federal Reserve should have raised short-term interest rates more aggressively over [the 2004-07] period.

That basic framework pertains to how the Fed intends to move toward more normal levels of interest rates and asset holdings. I suspect some of you are just as avidly interested, if not more so, in when and how rapidly the Fed will raise rates. I hate to disappoint you, but the truth is nobody knows yet. There is no pre-set timetable for raising rates. The FOMCs actions genuinely will depend on the economic data available at the time. So I cannot tell you when and, more importantly, how rapidly our rate target will rise.

I will share an observation, however. The economic outlook can change rapidly, and judgments about appropriate policy need to respond accordingly. Its not hard to find historical examples: The outlook for real activity shifted dramatically from late 1998, when overseas turmoil was thought to jeopardize U.S. growth, to early 1999, when it became clear that the effects would be minimal and activity was accelerating. Similarly, the outlook for growth and inflation shifted significantly from mid-2003, when inflation seemed to be sinking below 1 percent, to early 2004, when growth and inflation were clearly rising. Arguably, the Fed fell at least somewhat behind the curve in each case. The lesson, I believe, is that policymakers should strive to look through clearly transitory phenomena to assess the underlying real economic developments that as long as inflation is anchored determine the appropriate path for interest rates. And they need to be prepared to respond promptly.

There certainly has been no, you know, decision on the part of the committee to move at a measured pace or to use a language like that.

I think quite a few people looking back on the use of that language -- I can't remember if it was 12 or 16 meetings where there were 25 basis point moves -- would probably not like to repeat a sequence in which there was a measured pace and 25 basis-point moves at every meeting. So I certainly don't want to encourage you to think that there will be a repeat of that.

Many members of the committee -- participants have said that they think policy should be based on the actual evolution of economic activity and inflation, which tends to be variable over time, and that's why I say I anticipate it will be data-dependent.

Looking back on the period, the run-up to the financial crisis, I don't think by any means measured pace and the very predictable pace of 25 basis points per meeting explains why we had a financial crisis, but it may have diminished volatility and been a small contributing factor. And the committee will have to think about how to do this. I think many people in the aftermath of that episode think that somewhat less of a mechanical pace would perhaps be better, but this is a matter that we will in due time have to discuss.

It is not uncommon to hear it suggested that the crisis could have been prevented or significantly mitigated by substantially tighter monetary policy in the mid-2000s. At the very least, however, such an approach would have been insufficient to address the full range of critical vulnerabilities I have just described. A tighter monetary policy would not have closed the gaps in the regulatory structure that allowed some SIFIs and markets to escape comprehensive supervision; a tighter monetary policy would not have shifted supervisory attention to a macroprudential perspective; and a tighter monetary policy would not have increased the transparency of exotic financial instruments or ameliorated deficiencies in risk measurement and risk management within the private sector.

Some advocates of the view that a substantially tighter monetary policy may have helped prevent the crisis might acknowledge these points, but they might also argue that a tighter monetary policy could have limited the rise in house prices, the use of leverage within the private sector, and the excessive reliance on short-term funding, and that each of these channels would have contained--or perhaps even prevented--the worst effects of the crisis.

[V]ulnerabilities from excessive leverage and reliance on short-term funding in the financial sector grew rapidly through the middle of 2007, well after monetary policy had already tightened significantly relative to the accommodative policy stance of 2003 and early 2004. In my assessment, macroprudential policies, such as regulatory limits on leverage and short-term funding, as well as stronger underwriting standards, represent far more direct and likely more effective methods to address these vulnerabilities.

"Bubble, Bubble, Toil and Trouble: A Dangerous Brew for Monetary Policy"

 ...

Sound policymaking requires us to understand the limits of what we know. I doubt we could find enough agreement among policymakers or economists about the interpretation of asset-price movements to allow for stable, rule-based policymaking. In the absence of such a clearly stated rule, we risk uncertainty about central bank policy itself as well as its effect on the economy... Humility in policymaking requires that we respect the limits of our knowledge and not overreach, particularly when it involves over-riding market signals with policy actions.

Another challenge in addressing asset-price bubbles in practice is that contrary to many economic models, in reality there are many assets, not just one. And these assets have different characteristics. For example, equities are very different from homes. Misalignments or bubble-like behavior may appear in one asset class and not in others. But monetary policy is a blunt instrument. How would monetary policy go about pricking a bubble in technology stocks in 1998 and 1999 without wreaking havoc on investments underlying other asset classes?

...

Indeed, I believe that we are discussing the question of asset prices and monetary policy today, at least in part, because Fed policy during mid-2000s “went off track.” John Taylor has argued forcefully that the Fed kept interest rates too low for too long from 2003 to 2005. As an erstwhile member of the Shadow Open Market Committee, I stood in this very room in 2003 and 2004, expressing concerns that the fears of deflation were excessive and that policy was probably too accommodative. The error may not have been that policymakers failed to pay attention to the fast upward rise in asset prices, but that they deviated from a systematic approach to setting nominal interests.

I think we’re in a liquidity trap where there is excess savings, greater than investment. It would take a lower real interest rates to address that.

But, look, if the right thing to do for the macro economy is to have lower interest rates but that comes with some risk for the financial system, we’ve only got one monetary policy tool and we have to focus on our mandate. But we have other supervisory tools which are supposed to  address emerging risks in financial markets. I think they have to be used.

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.

The job numbers lag the economy. Don’t misunderstand me. I think having people back to work is extremely important, but you don’t want your short term – your impatience about monetary policy -- to cause you to create new problems two years from now or two and a half years from now that cause people to lose their jobs again. So it’s that balance that’s using the policy in a careful, measured way that I think matters. I don’t know if I am seeing anything different, but I think I am trying to maximize the ability to assure that the recovery continues and we’re sure that we don’t end up with a new bubble down the line or inflation two, or three, or four years from now. Remember, interest rates were very low in 2001, 2002 and the effects of that really came much later and that’s what we have to keep in mind for the future.

Which version of the Taylor rule--the standard version, that uses current values of inflation, or the alternative version, that employs inflation forecasts--is the more reliable guide? I have explained my preference for using inflation forecasts rather than actual inflation in the policy rule: Monetary policy works with a lag, and therefore policy decisions must be forward looking. One might still prefer the simplicity of the standard Taylor rule that uses current inflation values. However, note from Slide 4 that a proponent of the standard rule would have recommended that the FOMC raise the policy rate to a range of 7 to 8 percent through the first three quarters of 2008, just after the recession peak and just before the intensification of the financial crisis in September and October--a policy decision that probably would not have garnered much support among monetary specialists. In contrast, Slide 4 shows that the version of the Taylor rule based on forecast inflation (in green dots) explains both the course of monetary policy earlier in the past decade as well as the decision not to respond aggressively to what did in fact turn out to be a temporary surge in inflation in 2008. This comparison suggests that the Taylor rule using forecast inflation is a more useful benchmark, both as a description of recent FOMC behavior and as a guide to appropriate policy.

My objective today has been to review the evidence on the link between monetary policy in the early part of the past decade and the rapid rise in house prices that occurred at roughly the same time. The direct linkages, at least, are weak...

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.

That said, having experienced the damage that asset price bubbles can cause, we must be especially vigilant in ensuring that the recent experiences are not repeated. All efforts should be made to strengthen our regulatory system to prevent a recurrence of the crisis, and to cushion the effects if another crisis occurs. However, if adequate reforms are not made, or if they are made but prove insufficient to prevent dangerous buildups of financial risks, we must remain open to using monetary policy as a supplementary tool for addressing those risks--proceeding cautiously and always keeping in mind the inherent difficulties of that approach...