The Fed's blunt tool

U.S. Federal Reserve Chairman Ben Bernanke said he was open to raising interest rates to deal with future market bubbles, but tough regulation was better.

In a prepared text for a speech for the American Economic Association in Atlanta, Ga., Bernanke said, "having experienced the danger that asset bubbles can cause, we must be especially vigilant in ensuring that recent experiences are not repeated."

"We must remain open to using monetary policy as a supplementary tool for addressing those risks -- proceeding cautiously and always keeping in mind the inherent difficulties of that approach," he said.

As far as snapping an economic adjustment into place, there are few fixes as quick and effective as adjusting interest rates on loans from the central bank. Higher rates diminish the attractiveness of money, effectively choking off the demand for loans, keeping money out of circulation, which tamps down on inflation. Easy money, on the other hand, encourages spending, which allows for inflation and devalues assets. If everyone can afford a McMansion, building another one undercuts their value at some point in time.

The Fed's mantra for the past six months has been the repeated phrase that interest rates would remain low "for an extended period of time," with some policy makers defining that as for at least another year. But economists are keeping an eye on the volatile housing market, where historically low bank-to-bank lending rates, now set at zero to 0.25 percent, have spurred demand with mortgage rates falling below 5 percent for much of the year. The market needs movement for builders, furniture makers and banks to survive. But all these sectors can be hurt by inflation and crippled by a bursting bubble, especially if the value of homes falls below the value of the loans, because at that point you have tossed the customer -- the homeowner -- under the bus. At that point, nobody wins.

A month ago, with the housing market was showing signs of a waning recovery, Sen. Richard Shelby, R-Ala., said, "while keeping interest rates low for a protracted period of time, the Fed seemed remarkably unconcerned about the possibility of igniting a different financial crisis by inflating a housing price bubble," The Washington Post reported Monday.

But Bernanke also said that the impact of interest rates on the housing market varies from country to country and "economists who have investigated the issue have generally found that, based on historical relationships, only a small portion of the increase in house prices earlier this decade can be attributed to the stance of U.S. monetary policy."

Other analysis point to the influx of money from abroad, most specifically from China, as having a greater influence on housing prices, Bernanke said.

In effect, Bernanke defined monetary policy as "a blunt tool," that can effectively do as much harm as good. While correcting a housing market bubble, "interest rate increases in 2003 or 2004 sufficient to constrain the bubble could have seriously weakened the economy at just the time when the recovery from the previous recession was becoming established," he said.

In international markets Monday, the Nikkei 225 in Japan rose 1.03 percent, while the Shanghai composite index in China lost 1.02 percent. The Hang Seng index in Hong Kong fell 0.23 percent, while the Sensex in India rose 0.54 percent.

In Australia, the S&P/ASX 200 rose 0.12 percent.

In midday trading in Europe, the FTSE 100 in Britain rose 1.08 percent, while the DAX 30 in Germany rose 1.11 percent. The CAC 40 in France rose 1.57 percent, while the pan-European DJ Stoxx 50 rose 1.3 percent.