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Too-low interest rates caused housing boom and bust, central bankers told

Section: Daily Dispatches

By Alister Bull
Saturday, September 1, 2007

JACKSON HOLE, Wyoming -- In rare public criticism of Alan Greenspan, former U.S. Undersecretary for International Affairs John Taylor said on Saturday that ultra-low Federal Reserve interest rates had stoked the U.S. housing boom and subsequent bust.

Greenspan, who retired as chairman of the Federal Reserve in January 2006, slashed rates to an ultra-low 1.0 percent to protect the U.S. economy after the collapse of the technology bubble, the September 11, 2001, attacks and fears of deflation.

"A higher federal funds path would have avoided much of the housing boom," Taylor said, drawing on a model he designed to simulate housing activity if the Fed had raised rates instead of aggressively easing borrowing costs.

Taylor, author of the famous Taylor Rule of central bank policy, presented his findings at an annual retreat for central bankers hosted by the Federal Reserve Bank of Kansas City in the Grand Teton mountains.

The symposium is examining the implications of the ongoing woes of the U.S. subprime mortgage market and collapse in credit which has roiled financial markets around the world.

Taylor, now an economics professor at Stanford University, designed the model to study what would have happened to U.S. housing starts if the Fed had been raising rates in 2002, in accordance with the recommendations of the Taylor rule.

U.S. house price inflation pierced a record 10 percent in the final three months of 2004 and maintained that pace for two years. Taylor said the buoyant market was directly responsible for a major improvement in home loan performance.

"With housing prices rising rapidly, delinquency and foreclosure rates on subprime mortgages also fell, which led to more favorable credit ratings than could ultimately be sustained," he said in the prepared text of his remarks.

Subprime mortgages are taken out by borrowers with risky or tainted credit histories and traditionally have been used to help lower income families get onto the property ladder.

"As the short-term interest rates returned to normal levels, housing demand rapidly fell, bringing down both construction and housing price inflation. Delinquency and foreclosure rates than rose sharply, ultimately leading to the meltdown in the subprime market," he said.

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