E-piphany

An editorial in the Journal on 7/30/09 asked whether New York Fed President Dudley is overreaching when he speculates about whether the Federal Reserve should try to target asset bubbles. The Op-Ed author, Donald Luskin, argued that they should not because let’s face it: their track record on seeing the bubbles after the fact isn’t great. These guys were worried about inflation in May of 2008.

I agree with Luskin that the Fed ought not to specifically target asset bubbles, but that doesn’t mean the Fed is powerless to prevent them. The Fed, in fact, has done a great deal to encourage them: not by lowering rates, per se, but by generally making the economic environment very safe and predictable: publicly announcing their thinking and their moves, working hard to save dumb players and to keep the economy from recession, and it’s those things that cause bubbles. Even if there is a bubble-bacterium present, that is, the Fed can restrain its growth by refraining from providing a warm, moist environment in which the bubble can prosper. If Dudley wants to prevent bubbles, all he needs to do is occasionally encourage the Fed to tighten 50bps rather than 25bps, and do it between meetings, without an announcement. Or just tighten 62.5bps and confuse investors. When investors are uncertain, they will act to preserve a margin of safety, and it is that which will keep bubbles from growing too rapidly.