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Should The Fed Target Asset Bubbles?

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.

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  1. Mark Voller
    December 8, 2009 at 4:25 pm

    Mike – I couldn’t agree more with your suggestion that policy moves should be implemented with an element of surprise.I might add that the accepted wisdom that in order to have a healthy economy,one needs a healthy banking system has been stretched to the point of idiocy.Gifting banks extraordinary profits via a steep yield curve directly subtracts from the wealth of the remainder of the economy -low savings rates for depositors and high borrowing rates for long term capital investors are both taxes on economic growth and shoul be recognised as such.Aim for a flat yield curve and a small banking system!

    • December 8, 2009 at 4:36 pm

      Mark – I think this will remain a robust topic for a long time. I agree with your remarks and I must say I am constantly bemused by the conviction among the political class…or maybe they’re just trying to convince us it is so…that you can give to Peter without any consequences for Paul. Thanks for your comment!

  2. Mike
    December 15, 2009 at 10:44 am

    To be honest, this problem is not as difficult as everyone makes it out to seem. Regardless of the certainty with which the Fed conducts policy, they can do a heckuva lot to prevent bubbles simply by having a rate level consistent with a sensible risk-reward premium, ie, higher short rates. I submit that the messes of the past decade were not caused so much by predictability of monetary policy as availability of cheap funds. The price of money dominates in the viability of a given investment strategy’s risk-reward equation.

    • December 15, 2009 at 10:55 am

      Mike, I don’t necessarily agree. If cash is very cheap but the Fed is stochastic, then that limits your leverage since the risk of the investment dominates. But if cash is expensive, but the Fed is very predictable, leverage can be quite high … indeed, since the hurdle rate will be higher, financial leverage must be higher to exploit a given mispricing. I don’t see how you can get as much leverage, no matter what the cost of money, if implied volatility is high.

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