In their widely-cited Wall Street Journal column last week, Ian Bremmer and Nuriel Roubini argue that to prevent asset price bubbles in the future the Fed should focus on “properly calculating asset prices and the risk of asset bubbles according to the Taylor rule, an important guideline central banks use to set interest rates.” Central bankers such as Bill Dudley and Kevin Warsh of the Fed and Mark Carney of the Bank of Canada also propose that asset prices be factored in to interest rate decision criteria such as the Taylor rule. Adding asset prices to the Taylor rule would be a big change because the Taylor does not now incorporate asset prices, and much research, including Ben Bernanke’s research ten years ago, shows it shouldn’t.
I agree that the Fed held interest rates too low for too long, and I provided evidence of this at the summer 2007 Jackson Hole conference. But the problem was not that the Fed ignored the housing boom. The problem was that it caused it. Look at the nearby chart from The Economist. It shows the Taylor rule without any asset prices and the actual interest rate. Clearly interest rates were too low. By deviating from the rule and keeping interest rates too low, the Fed caused the acceleration in housing prices. If the Fed had simply conducted monetary policy as it had in the 1980s and 1990s, we would likely not have had the housing boom.