Federal Reserve Chair Ben Bernanke spoke yesterday at the American Economic Association annual meeting, in Atlanta, and he defended the Fed against the claim "that excessively easy monetary policy by the Federal Reserve in the first half of the decade helped cause a bubble in house prices in the United States, a bubble whose inevitable collapse proved a major source of the financial and economic stresses of the past two years."

Among the issues Bernanke addresses in his defense of Fed policy is the oft-repeated charge "that monetary policy was too easy during the period from 2002 to 2006."  

The aggressive monetary policy response in 2002 and 2003 was motivated by two principal factors. First, although the recession technically ended in late 2001, the recovery remained quite weak and "jobless" into the latter part of 2003. Real gross domestic product (GDP), which normally grows above trend in the early stages of an economic expansion, rose at an average pace just above 2 percent in 2002 and the first half of 2003, a rate insufficient to halt continued increases in the unemployment rate, which peaked above 6 percent in the first half of 2003.³Second, the FOMC's policy response also reflected concerns about a possible unwelcome decline in inflation. Taking note of the painful experience of Japan, policymakers worried that the United States might sink into deflation and that, as one consequence, the FOMC's target interest rate might hit its zero lower bound, limiting the scope for further monetary accommodation. FOMC decisions during this period were informed by a strong consensus among researchers that, when faced with the risk of hitting the zero lower bound, policymakers should lower rates preemptively, thereby reducing the probability of ultimately being constrained by the lower bound on the policy interest rate.

Bernanke also took on the question of whether the Fed funds rate being, on average, 200 points below the values "implied by the Taylor rule" proves that monetary policy was too easy. (click here for a slide of the Fed funds rate vs the Taylor Rule values).   Bernanke argues that a fair assessment of the Fed's approach requires a comparison with the an adjusted, or alternative Taylor rule. Here's a slide Bernanke used during this portion of the speech:

Bernanke:

The distinction between current and forecast values does not always matter much, as (for example) high levels of inflation or output today may signal high levels of those variables in the future. However, over the past decade, the distinction between current and forecast inflation has been an important one. On several occasions during this period, surges in energy prices led to increases in overall inflation. According to the standard Taylor rule, whose policy prescription depends on the current value of inflation, these episodes should have led to a significant tightening of monetary policy. However, both the FOMC and private forecasters expected these increases in energy prices to subside--correctly, as it turned out--and therefore did not much adjust their medium-term forecasts for inflation. Consequently, policy was not tightened as much as would have been called for by the standard Taylor rule. Put another way, the standard Taylor rule makes no distinction between increases in inflation expected to be temporary and those expected to be longer lasting. In practice, however, policymakers have responded less to increases in inflation that they expect to be temporary, a reasonable strategy given that monetary policy affects inflation only with a significant lag.

Slide 4 (above) shows the quantitative implications of this point. The actual paths of the policy rate, in blue, and the policy prescription implied by the standard Taylor rule, the dashed red line, are the same as in Slide 3. Also shown, as a dotted green line, is the monetary policy path prescribed by an alternative version of the Taylor rule that replaces the current rate of inflation on the right-hand side with a forecast of inflation over the current and subsequent three quarters. Forecasts are those that were actually made in real time, that is, at the time at which the corresponding policy rate was chosen.

Read the full speech here.