As an economic forecasting body, the Fed has failed by not recognizing the bubble for what it really is. However, arguably it has done as much as is humanly possible to protect the financial markets from themselves. In addition, it is neither commissioned nor equipped to protect the economy against asset bubbles in the first place. Instead of complaining that the Fed should have done things differently, the GFC (and indeed many of the bubbles or financial excesses before it) should open discussion of whether the existing system of economic and financial supervision should be structured differently.
There has always been asset bubbles and financial failures in the course of human history. Hence it cannot be said as a default that the housing bubble is caused by the Fed. The question should be: would asset bubbles created a lot more havoc without the Fed? There is no easy way of answering this. Based on historical evidence, the answer would be yes. Bubbles have not generated economic downturns of the kind seen in the Great Depression since the modern central banking system was introduced. Even the latest Great Recession has been more moderate.
A lot of criticisms focus on how Fed flooded the market with liquidity and induced low interest rates through-out the 90s and 00s, especially for its apparent aggressive loosening been accompanied by more conservative tightening. That criticism has validity, although it is more reflective of the limitations of a blunt instrument like monetary policy and the difficulty of economic forecasting. Using monetary policy to fine-tune the economy is unrealistic. According to Greenspan, this is why the Fed has consistently chose to err on the side of loose rather than tight economic policy. Improving the balance of this policy requires increased forecasting accuracy, which is arguably near-impossible. What can be done in the mean-time is making sure that political expediency does not affected policy decisions.
Its blunt policy instrument is but one indication that the Fed Reserve is not equipped to deal with asset or financial bubbles. Indeed, nor was it intended to either. Given how significant its decisions have on short term financial environment, people tends to see it having extensive responsibility for the economy, while its mandate is only to balance macroeconomic inflation and employment.
First looking at the macroeconomic side of its mandate. The Fed is not meant to make policy decisions while giving undue weight to particular industries or asset classes or geographies. That is within the purvey of other government institutions. Hence for instance, it will not make policy decisions based on conditions in one industry (e.g. housing).
Coming to inflation and employment, original mandate of the Fed is to ensure low upward pressure on cost of living while maximizing employment rate, with especial focus on the former. The cost of living would include consumer goods prices, but largely excludes asset prices like stocks, bonds, commercial real estate. Consumer prices also include cost of housing, but it is only one of the factors. Furthermore, it is debatabe how much weight to give to cost of purchase (house price) vs renting, since they are economically substitutable.
Given the lack of mandate, it will be politically suicidal for any Fed Board to tighten monetary policy to purely rein in prices of a particular asset class that ends up slowing down the economy.
In addition to the lack of clear mandate and the blunt nature of its policy instrument, there is no clear method or authority to determine whether there is a bubble (that is, asset prices are too high for the kind of return and risk profile). That is another reason Greenspan (and now Bernanke) have preferred to sit on the sidelines rather than participate vigorously (most of time they raise warnings in the media or advise the government to curb the asset appreciation).
While lacking mandate, will and means of further moderating asset bubbles, the Fed also know the bursting of such bubbles will have deep economic consequences like those experienced in the Great Depression. The end result of this conundrum is the pattern of Fed observing on side lines on the way up and scrambling to contain damage on the way down. When in scrambling mode, the Fed has increasingly sought ways of intervention beyond its the usual set of blunt policy instruments, as can be seen the bailing out of LTCM and various institutions during the latest crisis.
Hence it is not the Fed that caused or exacerbated the housing bubble (or more accurately, there is no evidence that the Fed has exacerbated the business cycle or financial market bubble-bust cycles over the long-run). Some may argue it could have done more and earlier to moderate the bubble, but its hands are tied by its mandate, its policy instruments and limitations of economic forecasting. In hindsight, there are a things the Fed could have done better such as shifting balance of error away from loose policy, be more proactive in warning about potential bubbles. However, these most likely would not have made much difference to the herd mentality of financial markets. To more effectively counter future asset bubbles, we should consider adequacy of the entire regulatory system.
The key inadequacy is that there is no single regulatory body tasked with supervision of financial and asset markets. In the housing bubble, this is reflected in the fact that despite warnings about risky mortgage lending practices, no supervisory institution had any interest to take strong action. The supervisory body need to have an overarching perspective (and hence cover all financial institutions, not just the banks), to avoid the narrow-minded thinking during the housing bubble that as long as banks are selling their securitized mortgages, the risk is absorbed by the market and hence disappears. Financial risk need to be assessed across the system.
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