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It has long been conventional wisdom that the Federal Reserve should not worry about asset bubbles: setting monetary policy without regard to the price of investments such as stocks or real estate. Those who hold this view doubt it's possible to identify investment bubbles anyway. Thus they believe the Fed should stick to worrying about inflation and the real economy; if a bubble does burst, the central bank's role is to clean up afterward and limit the economic damage. Recently this prescription has not worked particularly well, however. In the wake of both the late-1990s tech-stock bubble and this decade's housing bubble, the Fed was forced to slash interest rates with doubtful consequences for both financial markets and the real economy. The Fed's ultra-low rates after the stock bubble burst helped inflate the subsequent housing bubble, and the low rates in the wake of the housing collapse may contribute to a developing bubble in energy and other commodity markets. Ignoring bubbles may abet their creation. Cleaning up the economic mess from bursting bubbles has also proved difficult for the Fed. The financial system is the key conduit between monetary policy and the economy, and it is invariably a casualty of plunging markets. Lower rates can't help a struggling economy if they don't quickly translate into more and cheaper credit for businesses and households. It may, in fact, be possible to accurately identify bubbles. Not only are these characterized by rapidly rising prices, they also involve increased leverage, surging trading volumes, and the arrival of less sophisticated buyers to a market where they have little experience. It is true that bubbles are always born out of something fundamental be it the Internet's debut for stocks, low interest rates for housing, or Chinese demand for oil making it difficult to conclude in real time they are indeed bubbles. Yet policymakers are often asked to make judgments of equal, if not greater, difficulty. Will record oil prices undermine inflation expectations and result in higher underlying core inflation? Is a 2% funds rate target an appropriate response to the subprime shock? Was putting the Fed's balance sheet on the line to resolve the Bear Stearns collapse beyond the Fed's mandate? Asking whether there is a bubble in the housing market is not a more difficult question than these. Yet policymakers might argue credibly that higher interest rates are too blunt an instrument to wield against bubbles. And so we are back to a regulatory response. Bubbles need lots of credit, and regulators have many ways to affect the flow of credit. A Federal Reserve that determines the nation's monetary policy and is also its chief financial regulator could reduce the odds of future financial crises through deft use of its regulatory powers. This, however, requires that the central bank also demonstrates the courage of its convictions.
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