Bubble Poppers

Should the Fed be in the business of preventing asset bubbles?

The bursting of real estate and credit bubbles, the memory of the tech boom still fresh, and what may be the emergence of two new bubbles in commodities and green tech have Fed officials considering a move to dump the laissez faire stance of the Greenspan Doctrine.

Unlike his predecessor, Fed Chair Bernanke has not ruled out "leaning against the wind" -- a euphemism for cautiously raising interest rates -- to stop asset bubbles from forming. In a 2002 speech, Bernanke said arguments for leaning against the wind "are not entirely without merit." Not exactly ecstatic support, but still an opening.

Another Fed luminary, New York Fed Bank President Timothy Geithner, has voiced qualified support for targeting asset prices, saying in 2006 that the Fed "will need to respond to asset price movements" when these movements change the risks assumed in Fed forecasts. And if you think about it, the Fed reacts to negative price shocks, so why not positive ones too? But as the Financial Times reports, any move by the Fed to pay closer attention to assets like stocks and real estate will be a "radical break" from past practice.

What has kept most any central bank from getting in the way of booms is that conducting monetary policy through interest rate targets is unwieldy. Most importantly, it's not easy to identify bubbles in advance, so central bankers run the risk of needlessly stunting growth. It's also not clear that raising rates inch by inch will do anything to halt overly exuberant investors. And different asset classes don't respond in the same way to tightening or relaxing. Stocks, for example, typically react faster to policy changes than do home prices.

The argument could even be made that the Fed is fine the way it is: After going through the worst financial crisis since the Great Depression, it's looking more and more like the recession we all thought would wallop the U.S. economy will either be a no-show or only last a short bit, thanks in part to the Fed's gymnastics.

But despite this, it's likely that with the innovations the Fed introduced to prevent the credit crunch from worsening, it won't be long before the the central bank's role is officially redefined.

Treasury Secretary Henry Paulson's plan to overhaul the financial system -- a non-starter, but it could still be a blueprint for future measures -- would turn the Fed into the main overseer of market stability.

Although the Fed has been shy to use even its more direct regulatory tools in the past -- the bank came under fire for not using its power to clamp down on risky mortgage lending practices -- it's a positive sign that officials are giving serious thought to preventing booms from turning to bubbles, says Morris Goldstein of the Peterson Institute.

The problem in the past was that the Fed said its job was not to identify and prick bubbles, but "they also told the regulators well you shouldn't do it either because there's no reason to assume you know more than the guys making the loans," Goldstein says in the case of the subprime debacle. That leaves the system no way to stop bubbles before they collapse and cause unnecessary harm. In these cases, Goldstein adds, "the only policy instrument you have left is a large mop."