Alan Greenspan today writes in the WSJ that "The Fed Didn't Cause the Housing Bubble." He asserts that "it was indeed lower interest rates that spawned the speculative euphoria. However, the interest rate that mattered was not the federal-funds rate, but the rate on long-term, fixed-rate mortgages." He blames the bond market for setting long-term interest rates too low.
Well, as George Will would say. We are thus left to conclude that the Fed can set the funds rate wherever it pleases, and things will only go awry if the bond market misjudges where long-term rates should be. Greenspan further defends his now-tarnished legacy by attacking John Taylor for promoting the mistaken notion that the Fed kept short-term interest rates too low.
I have my own explanation for what happened. I think the Fed was at least partially responsible for the housing boom, and government subsidization of borrowing costs (e.g., via Freddie and Fannie, the home mortgage deduction, the Community Reinvestment Act, and favorable capital gains tax treatment) did the rest. Monetary policy was generally inflationary following the 2001 recession, as evidenced by rising prices of almost all tangible goods: gold, energy, commodities, and real estate. Interest rates were in general not high enough to offer a compelling alternative to borrowing money and buying hard assets. The housing boom was copied in the commodity and energy markets. That is how monetary inflation works.
The Fed only sets the overnight interest rate, but the Fed can and does influence interest rates along the rest of the yield curve through its actions and its statements. When the Fed tells the world that it will keep interest rates extremely low for a long period, as it did in 2003, the bond market assumes that inflation is not a problem and sets long-term interest rates at levels that it believes are consistent with a reasonable expectation of where the funds rate is likely to be in a noninflationary future.
The corollary to this view of how Fed policy works is that the bond market is not always a good predictor of inflation, and it can and does make mistakes. But that doesn't absolve the Fed of blame. If the Fed had paid more attention to commodity prices, and in particular gold, it would have realized by late 2003 that policy was too easy, and it would have moved sooner to tighten. That might well have mitigated the subsequent housing boom, as well as the commodity and energy price roller coaster that has rocked the global economy.
UPDATE: A new book by John Taylor, "Getting Off Track" appears to do a good job of describing how this whole crisis evolved.