What the Fed is Avoiding in its Bubble Discussions

More discussion is emerging across the blogosphere (here, here, here, and here) on how monetary authorities can better manage asset bubbles. This discussion has emerged in response to the Federal Reserve's own growing interest in this issue. The Financial Times first reported this development a few days ago and now the Wall Street Journal in both its print edition and in its RTE blog (here, here, and here) have been providing additional coverage. What we have learned so far about the Fed's thinking is that while it is open to using prudential regulation and monetary policy in stemming future asset bubbles, it is less enthused about the latter option. (This bias toward prudential regulation was especially clear in the speech last night of Fed governor Frederick Mishkin.)

Interestingly, what little discussion has been given to the monetary policy option has been framed around how monetary policy should respond given there is an asset bubble (e.g. prick it by increasing interest rate). What is not being discussed by Fed officials--at least I am not aware of any such discussions--is whether loose monetary policy itself helped create the U.S. asset bubbles of past decade. Ignoring this facet of the debate means ignoring discussions on how to improve the conduct of monetary policy so that it minimizes the emergence of asset bubbles in the first place. The RTE blog reports in a similar vein:

But amidst all this debate, the Fed has not dwelled much on the role its own monetary and regulatory policies may have played in fueling the housing bubble. James Bianco of Bianco Research complains that the Fed has looked everywhere for a solution but at itself. “It seems that the Federal Reserve thinks bubbles are caused be everyone and everything except, say, a 1% fed funds rate or special liquidity facilities,” he writes in a commentary today. If Mr. Mishkin wants to use the Fed’s powers more proactively to arrest bubbles, he “should stop voting for irresponsible expansions of Federal Reserve credit that create and promote bubbles.

While I differ with James Bianco regarding the Fed's clever use of its balance sheet to stem the current credit crisis, I do agree with the spirit of his argument--the Fed's loose monetary policies in the past was the fuel that started the asset bubbles. At a minimum it would be worthwhile to consider the asset price implications of its past policies and whether alternative approaches could do better. I have already expressed my view on this matter: the Fed would do a better job minimizing asset boom-bust cycles by adopting a nominal income targeting rule.

Let me close by noting that the Fed's is late in joining this debate. The Europeans have been thinking about these issues far longer. In particular, I would point any interested reader (or Fed official) to the works of Claudio Borio, Andrew Filardo, William White, and others at the BIS. These observers take seriously improving both prudential regulation and monetary policy. Here is a posting of mine that provides some links to their works.