Policy Shift: Can the Fed Identify & Pop Asset Bubbles?

Thursday, May 15, 2008 | 06:45 AM

Interesting discussion in the FT Wednesday about a potential major shift in Fed philosophy: Maybe its a bad idea for Central Banks to passively wait for bubbles to pop. 

I am not sure if the Fed will shift away from the Greenspan doctrine: "Inflate Bubbles & Clean Up he Mes After." Will the change be to something less disruptive, or will they throttle the growth side of the equation? That's the risk.

Perhaps one idea worth exploring might be not to not blow these bubbles in the first place.

Here's an excerpt from the FT:

"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 . . .

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."

Greenspan has claimed its impossible to identify bubbles in real time; Ben Bernanke has been more contemplative on the subject. He's said its "difficult" to know for sure when we are n a bubble.

Chairman, let me suggest a few data  points worth considering:

Standard Price Deviations: Is the asset class trading 2 to 3 standard deviations away from its traditional price metrics?

Inventory: Is there a huge inventory build? Bubbles create the incentive to produce a whole lot more, be it Miami condos or dot com companies.

Fundamentals: Has something shifted in the fundamental supply/demand equation that is impacting pricers, or is it pure speculation?

Regulatory Changes: Has the government altered some part of the equation that might have changed the game somewhat?

There are others, but these are a good beginning.

Note that the inventory metric is why I have doubted commodities are a bubble; also I have long claimed  that we did not have a national Housing bubble, but instead had a lending & credit bubble -- a subtle but important distinction. 

By the same metrics, I agree with I agree  Stuart Hoffman, chief economist of PNC Financial, who notes that the enormous volume of new condos in Miami in inventory are just that proof of a local bubble (I agree).

>

UPDATE: May 16, 2008 5:42am

WSJ:

First came the tech-stock bubble. Then there were bubbles in housing and credit. Chinese stocks took off like a rocket. Now, as prices soar on every material from oil to corn, some suggest there's a bubble in commodities.

But how and why do bubbles form? Economists traditionally haven't offered much insight. From World War II till the mid-1990s, there weren't many U.S. investing manias for them to look at. The study of bubbles was left to economic historians sifting through musty records of 17th-century Dutch tulip-bulb prices and the like.

The dot-com boom began to change that. "You were seeing live, in action, the unfolding of lots of examples of valuations disconnecting from fundamentals," says Princeton economist Harrison Hong. Now, the study of financial bubbles is hot.

Marketwatch:

Fed should deflate some bubbles, Mishkin says 

The Federal Reserve should try to aggressively deflate some types of asset bubbles before they can harm the economy, Fed Gov. Frederic Mishkin said Thursday.

But raising interest rates isn't the way to prick a bubble, he said. And some types of bubbles, such as the dot-com bubble of the late 1990s, probably shouldn't be pricked at all, he said.

On the other hand, the housing bubble of this decade was the type of bubble that should have been targeted with closer supervision and tighter regulation to prevent widespread economic damage, Mishkin said.

The Fed should watch for bubbles that are associated with a fast expansion of credit, he said, because these bubbles have the potential to inflate bank balance sheets on the way up and destroy them on the way down.

>

Sources:
Fed looks at ways to fight asset bubbles
Krishna Guha
FT, Tuesday May 13 2008 18:05
http://us.ft.com/ftgateway/superpage.ft?news_id=fto051320081916203957

Bernanke's Bubble Laboratory
Princeton Protégés of Fed Chief Study the Economics of Manias
JUSTIN LAHART
WSJ, May 16, 2008; Page A1   
http://online.wsj.com/article/SB121089412378097011.html

Fed should deflate some bubbles, Mishkin says
Monetary policy ineffective, but supervision can break harmful feedback loops
Rex Nutting
MarketWatch, 7:04 p.m. EDT May 15, 2008
http://tinyurl.com/4wk673

Thursday, May 15, 2008 | 06:45 AM | Permalink | Comments (47) | TrackBack (0)
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Comments

What's the biggest bubble to pop with this change in Alan Greenspan's only contribution to Central Bank thinking? Greenspan's un-deserved reputation for competence.

Now that's over with move on and defend the currency.

Posted by: VennData | May 15, 2008 7:05:17 AM

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