Martin Wolf is certainly right in suggesting that a principal lesson of today's financial market debacle is that central banks must target more than just inflation. He is also correct in suggest that central banks need to be keenly alert to the formation of excessive asset price bubbles. However, by focusing exclusively on the Fed's overly accommodative interest rate policy between 2000 and 2006, he seems to underplay the perhaps even greater role that was played in the US housing market bubble by the Federal Reserve's egregious regulatory failure over that period. It would seem that even had the Federal Reserve followed a Taylor rule in setting interest rate policy, we would still have had a damaging housing market bubble due to a massive loosening of mortgage lending standards as a result of the very poor regulation of that lending.
A key lesson that should be drawn from the fall out of the US housing market bubble is that the Federal Reserve can ill-afford to be derelict in the exercise of its regulatory responsibilities. More specifically, there can be no excuse for the Federal Reserve's having tolerated the very poor lending practices of the non-bank mortgage originators, which relied heavily on an originate-to-distribute model and which accounted for around half of all mortgage originations between 2004 and 2006. Nor should the Federal Reserve be absolved of responsibility for having allowed more than US$2 trillion in sub-prime and Alt-A mortgages to have been extended at loan to value ratios often approaching 100 percent and to borrowers who by all accounts were patently not creditworthy.
It would seem that, over the period 2000 to 2006, the Federal Reserve was equipped with both an interest rate instrument and a regulatory instrument that should have allowed it to better attain the two objectives of containing price inflation and of preventing the formation of destructive asset price bubbles. Sadly, the Federal Reserve was far too accommodative in its interest rate policy and highly irresponsible in the exercise of its regulatory authority.
Desmond Lachman is a resident fellow at AEI.