Financial planninf advice July/1

Should the Fed be in the business of pricking asset bubbles?

This week, we step back a moment to think about monetary policy. Still, the Fed faces severe downside risk to the economy – commercial real estate and state and local budgets alone cause havoc on the outlook. Furthermore, the Fed will likely be in easing mode for some time, especially with the pile of assets it must eventually unwind.
However, the future of Fed policy is being challenged. Last week, the Board of Governors Vice Chairman, Donald Kohn, defended the Fed’s need for autonomy from Congressional oversight, as “Any substantial erosion of the Federal Reserve’s monetary independence likely would lead to higher long-term interest rates as investors begin to fear future inflation”.1 As the economy recovers from the grandest housing bubble in modern history, the Fed will once again assess its mandate to promote maximum sustainable employment, stable prices, and moderate long-term interest rates. Should this mandate include a policy of targeting asset prices?
Bill Cheney
Chief Economist
617-572-9138
bcheney@mfcglobalus.com
Oscar Gonzalez
Economist
617-572-9572
ogonzalez@mfcglobalus.com
Rebecca Braeu
Economist
617-572-0868
rbraeu@mfcglobalus.com
Economic Research
The short answer is going to be YES and NO. Yes, the Fed and related agencies should further explore their roles as financial regulators, which is part of the Fed’s job of ensuring financial stability. No, even a pre-emptive strike against asset prices requires that the Fed reliably identify the bubble given the information at the time. Furthermore, the Fed’s dull monetary policy tool, the short-term rate, is likely to rip through key macroeconomic variables while slowing down asset-prices.
The evidence supporting a policy of targeting asset prices is mixed at best. Furthermore, in the last year it has become abundantly clear that the Fed’s toolbox is more fluid than previously thought - there is a much to do in the area of regulation before changing its policy toward pricking bubbles.
Why do bubbles matter?
The Fed already follows asset prices to the extent of their effects on the real economy. Asset prices affect consumer spending behavior via wealth effects (tangible, housing, and non-tangible, financial, wealth). Second, stock prices affect the ability of firms to raise funds for growth and new investment.
Research shows that the Fed already incorporates asset prices into its policy decisions. According to Rigabon and Sack (2003)2, the probability that the Fed eases (tightens) increases by roughly 50% in the face of a 5% shock to the S&P 500. Simply put - the Fed currently reacts to the expected macro-economic instability that is caused by asset pric