Fed looks at ways to fight asset bubbles

Fed looks at ways to fight asset bubbles

By Krishna Guha in Washington

Published: May 13 2008 23:56 | Last updated: May 13 2008 23:56

The US Federal Reserve is reconsidering the way it deals with asset price bubbles in the wake of the housing and credit bust, in a move that could see the central bank using regulation – or even interest rates – to fight unjustified increases.

Top officials are re-examining the Alan Greenspan doctrine that central banks should not try to tackle asset bubbles and should focus on mitigating the fallout when they burst.

They are open to the possibility that the Fed may have to adopt a different strategy in future. However, they have not reached any conclusions and could end up reaffirming their traditional hands-off stance.

Any move by the Fed to focus more explicitly on asset prices rather than simply take into account their expected effect on growth and inflation would be a radical break.

The Fed has long stood out among central banks as the least willing to embrace the idea that it should “lean against the wind” when asset prices are rising ­rapidly.

Former chairman Mr Greenspan famously argued that it was in practice impossible to identify bubbles before they burst, and attempts to prick them by raising rates were likely to do more harm than good.

Ben Bernanke, current chairman, endorsed the Greenspan view in 2002 following the bursting of the dotcom bubble, though with the caveat that central banks should use microeconomic regulation to mitigate the risks caused by bubbles.

Six years on, Mr Bernanke still believes it is hard to know when a bubble is a bubble. But he and other top officials are reviewing the Fed approach following the second big and disruptive bubble in a decade.

One option would be for the Fed to tackle bubbles with monetary policy, setting interest rates higher than they would otherwise be when asset prices appear to be inflating beyond levels justified by economic fundamentals.

Mr Bernanke rejected this approach in 2002 but is willing to re-evaluate it in the light of recent events.

Still, he and other top officials remain sceptical that “leaning against the wind” with interest rates is an effective strategy. They regard interest rates as a blunt tool for the job because they affect the economy and asset markets as a whole, not the specific market with a bubble.

By contrast, there is widespread interest inside the Fed in using regulatory policy more aggressively to try to contain bubbles. Officials are intrigued by the extra possibilitie that could be opened up by proposed new powers set out in a Treasury blueprint for regulatory reform.

The Treasury recommends giving the Fed wide authority to require financial institutions to alter behaviour that it believes poses a threat to financial ­stability.

However, Fed policymakers regard it as a proposal that needs extensive development.