Friday, March 28, 2008

Is the Fed Rethinking Its Policy Toward Asset Bubbles?

From Bloomberg:

Federal Reserve officials may be rethinking their aversion to acting against asset-price bubbles, an article of faith during former Chairman Alan Greenspan's 18 years at the helm.

After this month's near-collapse of Bear Stearns Cos., Minneapolis Fed Bank President Gary Stern -- the longest-serving policy maker -- said in a speech yesterday that it's possible ``to build support'' for practices ``designed to prevent excesses.'' New York Fed President Timothy Geithner, whose district bank took on almost $30 billion of Bear Stearns assets to rescue the firm, argued two years ago for a larger role for asset prices in decision-making, and there's no indication his views have changed.

For Fed policy makers, ``the consequences of their permissiveness have become so disastrous that they simply can't keep singing the same old tune in public,'' said Tom Schlesinger, executive director at the Financial Markets Center in Howardsville, Virginia.

While the soul-searching is unlikely to result in immediate changes to monetary policy, Stern's comments show how the credit freeze has forced officials to scrutinize long-held philosophies about the Fed's role in markets, and even ask how their current policies may undercut those views.

``As a risk manager, the Fed needs to take account of both directions, not just dealing with the aftermath,'' said Bruce Kasman, chief economist at JPMorgan Chase & Co. in New York. ``We have had two asset-prices bubbles in the last 10 years that have had big implications for the Fed's desire for a more stable macroeconomy.''

While it is easy to criticize the Fed for its lax policies (God knows I have done it many times), the reality is the situation is far more complicated. When the economy is slowing (as it is now) lowering rate is the primary method the Fed has to soften the landing. However, how low is too low? At what point do low rates which are supposed to stimulate economic growth become excessively low, encouraging reckless behavior? And how soon after the economy comes out of a recession should the Fed raise rates? This is a difficult balancing act.

However, I am pleased to see a tacit understanding from the Fed that their policies have in fact been a reason for today's problems. Something I am sick and tired of hearing is the "we had no idea this would happen" defense -- especially from a bunch of economists who are well aware of basic supply and demand. When Greenspan tells everyone that he had no idea the reckless lending would happen it takes all of my resolve not to throw large objects at the television screen.