Tuesday, January 05, 2010

Baum Makes Mincemeat of Bernanke's Twisted Logic

In Ivory Tower Doesn’t Have a Mortgage, http://www.businessweek.com/news/2010-0 ... -baum.html Bloomberg columnist Caroline Baum makes mincemeat out of Bernanke's twisted defense of Fed policy.

Bernanke takes great pains to rebut criticism that the funds rate was well below where the Taylor Rule, developed by Stanford economist John Taylor, suggested it should be following the 2001 recession.

Substitute forecast inflation for actual inflation, and the personal consumption expenditures price index for the consumer price index, and -- voila! -- monetary policy looks far less accommodating, Bernanke said.

It’s always easier to start with a desired conclusion and retrofit a model or equation to prove it.

What if easy money is a necessary but not sufficient condition to explain the magnitude of housing bubbles across countries?

The real fed funds rate was negative from 2002 to 2005, the longest stretch since the 1970s, a decade notable for high inflation and unemployment. The teaser rates lenders offered on ARMs were pretty close to zero when adjusted for inflation.

When you can borrow for free and invest in an asset whose price can only go up (at least that was the perception about home prices), guess what happens? Credit is misallocated. Lending standards decline. Everyone wants in.

Yes, monetary policy is a blunt instrument, as Bernanke pointed out. Keep rates too low -- create too much money -- and sometimes that money chases goods and services prices, which we designate as inflation. Other times it piles into certain assets, which we call a bubble.

“The best response to the housing bubble would have been regulatory, not monetary,â€