Fed: Regulation 1st defense against speculation

[January 04, 2010]  WASHINGTON (AP) -- Stronger regulation is the best way to prevent financial speculation from getting out of hand and throwing the economy in a new crisis, Federal Reserve Chairman Ben Bernanke said Sunday.

But he didn't rule out higher interest rates to stop new speculative investment bubbles from forming.

The Fed chief's remarks were his most extensive on the subject since the housing market's tumble led to the gravest financial crisis since World War II -- and perhaps the worst in modern history, in his view.

Critics blame the Fed for feeding that speculative boom in housing by holding interest rates too low for too long after the 2001 recession.

But Bernanke, in a speech to the American Economic Association's annual meeting in Atlanta, defended the central bank's actions. Extra-low rates were needed to get the economy and job creation back to full throttle after the Sept. 11 attacks and accounting scandals that rocked Wall Street, he said.

Bernanke said the direct links were weak between super-low interest rates and the rapid rise in house prices that occurred at roughly the same time. The stance of interest rates during that period "does not appear to have been inappropriate," he said.

Still, the enormous economic damage from the housing bust -- the longest and deepest recession since the 1930s and double-digit unemployment -- shows how important it is to guard against a repeat, Bernanke said.

"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," he said.

"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," he added.

Speculative excesses are not easy to pinpoint in their early stages, he said, and using higher interest rates to combat them can hurt the economy.

For instance, rate increases in 2003 and 2004 to constrain the housing bubble could have "seriously weakened" the economy just when a recovery from the 2001 recession was starting, he said.

To help the country emerge from that recession, the Fed under then-Chairman Alan Greenspan cut its key bank lending rate from 6.5 percent in late 2000 to 1 percent in June 2003. It held rates at what was then a record low for a year. It's this action that critics blame for feeding the housing speculation.

Bernanke, however, said the expansion of complex mortgage products and the belief that housing prices would keep rising were the keys to inflating the housing bubble. As a result, lenders made home loans to people to finance houses they couldn't afford.

The Fed in 2005 did crack down on dubious mortgage practices and the type of mortgages blamed for the crisis. Bernanke acknowledged that these efforts "came too late or were insufficient to stop the decline in underwriting standards and effectively constrain the housing bubble."

Still, Bernanke said the lesson learned from the crisis isn't that regulation is ineffective but that regulation "must be better and smarter."

However, the Fed's regulatory lapses and its failure to spot problems leading up to the crisis have spurred efforts in Congress to rein in the Fed's powers and subject it to more oversight. Bernanke, who has been tapped by President Barack Obama to a second term as Fed chief, faces a contentious confirmation in the Senate.

During a brief question-and-answer session after his speech, Bernanke didn't talk about current economic conditions or the future course of interest rates.

When the Fed meets later this month, it is expected to keep its key bank lending rate at a record low, near zero. The big question is whether the Fed will provide clues at that time about when it will need to start raising rates to prevent inflation from taking off.

Some analysts worry that the Fed, which has held rates at record lows since December 2008, could be fueling a new speculative period and potentially a future economic crisis.

Looking back, Bernanke suggested the Fed might have underestimated the full force of the recession, which struck in December 2007. "It turns out the recession was worse than we thought at the time," he said.

After four straight losing quarters, the economy finally grew from July through September last year. Much of that growth, though, came from government-supported spending on homes and cars. There's concern about how vigorous the recovery will be once government supports are removed later this year.

[Associated Press; By JEANNINE AVERSA]

Associated Press writer Dorie Turner in Atlanta contributed to this report.

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