At Econbrowser, James Hamilton has many interesting posts from the annual Fed conference at Jackson Hole, where the housing kerfluffle drew a lot of attention. In one post, he writes,

But if it were the case that all these institutional changes are just a response to interest rates, it means that the lags in the monetary transmission process are substantially longer than many of us had supposed. If people were still buying houses in 2006 as a result of institutions that sprung up from the conditions in 2004,it means that, if we thought in 2004 that overstimulation could easily be corrected by bringing rates back up, then we would have been wrong. And likewise, suppose you believe that the pain we’re seeing now, and may continue to see for a matter of years, until the new loan originators all go out of business, and recent buyers are forced out of their homes, is simply a response to a monetary tightening that ended a year ago. If so, then if we think today that, if things get really bad, we can always fix things by rapidly bringing interest rates back down– well, then, once again, we’d be wrong.

He is trying to compare two types of explanations for the problem in subprime mortgages. One explanation is that the system for managing risk broke down, and investors made decisions that in retrospect were clearly stupid. In that case, perhaps some regulation is in order. (My view would be that such regulation would be classic post-horse barn-door closing, with little or no constructive effect.)

Another explanation is that the monetary environment somehow inevitably caused people to lose track of risk. This is a seductive story, in that clearly some people misjudged risk badly, and in a different (tighter) monetary environment they would probably have been brought to their senses sooner. But I think that one should resist the seduction of that story.

The goal of monetary policy should be to maintain an environment of low inflation. In an environment of low inflation, if investors set risk premiums low, then there will be a boom. That boom may be followed by a slump. I do not think that the Fed should try to fine tune its way through those sorts of cycles. By trying to stick to an inflation target, the Fed is doing enough to lean against the wind.

I see movements in risk premiums as not particularly predictable. The timing and magnitude of the effect of these movements on macroeconomic performance is another source of uncertainty. The economy itself seems to be much less volatile than financial markets. For the Fed to start to key off financial markets in making policy seems to me like a recipe for greater instability, not less.