How the Fed Can Minimize Asset Bubbles

The Financial Times (FT) is reporting that the Federal Reserve is looking for new ways to fight the assets bubbles of the future. In addition to better prudential regulation, the Fed is even considering--gasp--using its policy rate to nip an asset bubble in the bud. If you have been following the debate of asset bubbles at the Fed you will know this is a radical departure from past thinking. In the words of the FT:

The US Federal Reserve is reconsidering the way it deals with asset price bubbles in the wake of the housing and credit bust, in a move that could see the central bank using regulation – or even interest rates – to fight unjustified increases.

[...]

One option would be for the Fed to tackle bubbles with monetary policy, setting interest rates higher than they would otherwise be when asset prices appear to be inflating beyond levels justified by economic fundamentals.

Mr Bernanke rejected this approach in 2002 but is willing to re-evaluate it in the light of recent events.

Better prudential regulation and a willingness to take into consideration the possibility of asset bubbles in the conduct of monetary policy is progress. The tricky part, though, is how to modify monetary policy so that is responds in a systematic way to asset bubbles. One approach would be to simply add asset prices to a Taylor rule. However, even in a forward-looking Taylor rule with asset prices, monetary policy would only be responding to an asset bubble after it had emerged, after the asset bubble horse is already out of the barn. (This is because asset bubbles--which by definition are not based on fundamentals--cannot be predicted.) Would it not better to have a rule that minimized the emergence of asset bubbles in the first place?

I believe a nominal income targeting rule is just such a rule. In fact, for some time I have argued here that monetary authorities may actually increase macroeconomic volatility by aiming to stabilize some form the price level (e.g. inflation targeting), rather than nominal income. My reasoning has been that changes in aggregate productivity that are offset by monetary authorities, so as to maintain price level stability, can lead to economic imbalances. For example, in this post I said the following:

Imagine the U.S. economy is buffeted with a series of positive productivity shocks that increases aggregate supply. This development would put downward pressure on the price level and set off the deflation red alert sign at the Federal Reserve. Now, in order to keep the price level from falling, the Federal Reserve must act to increase nominal spending. If this change in monetary policy were unexpected, or if there were significant nominal rigidities (i.e upward sloping Short-run aggregate supply curve), the nominal spending increase that stabilizes the price level would also push actual output beyond its natural rate level. Hence, there would be both a sustainable component—the productivity gains—and a non-sustainable component—the monetary stimulus—to the subsequent increase in real output. Moreover, the unsustainable pickup in actual output would occur without any alarming increases in the price level ... The increase in nominal spending could thus create a boom-bust cycle in real economic activity without any of the standard inflationary signs of overheating.

In this scenario, had monetary authorities stabilized nominal spending--allowed the price level to fall while output increased--there would have been no positive output gap. Consequently, it would have been better for monetary authorities to stabilize nominal spending through a nominal income targeting rule. Note, that this understanding would also have implications for interest rates:

These developments could also be viewed from an interest rate perspective. Here, the Wicksellian view that the actual real rate of interest can deviate from the natural rate of interest in the short run is invoked. The natural rate of interest is the real interest rate justified by non-monetary fundamentals, specifically the productivity of capital, the labor supply, and individuals’ time preferences and is the real interest rate consistent with the natural rate level of output. Recall that an increase in the growth rate of productivity should be matched by a similar increase in the natural rate of interest. If, however, monetary authorities attempt to offset the productivity-generated deflationary pressures by lowering the policy interest rate, they may force the actual real interest rate below the natural interest rate. This response can create an unsustainable credit boom. The resulting macroeconomic disequilibrium will be manifested in unwarranted capital accumulation, excessive leverage, speculative investments, and inordinate asset prices...

Here again, in this scenario--which sound eerily familiar to the U.S. economy during 2003-2005--had monetary authorities instead stabilized nominal spending the real rate of interest would not have fallen below the natural rate of interest. To the extent a nominal income monetary policy rule prevents an asset bubble from emerging in the first place, it would be better than a Taylor rule that responds after the asset bubble formed. So how about it Chairman Bernanke and other member of the Fed: what do you think about a nominal income targeting rule as means to minimizing asset bubbles?

Update: Take a look at this nominal income targeting rule.