Asset bubbles like the real estate crisis rocking the economy are a policy concern for the government but not necessarily the Federal Reserve, says Federal Reserve Board Governor Frederic S. Mishkin.
Mishkin, who recently announced he would step down from the Fed, was apparently responding to calls for the Fed to increase regulation of financial institutions in the wake of the credit crunch and mortgage market meltdown.
“Some asset price bubbles can have more significant economic effects and thus raise additional concerns for economic policymakers by contributing to financial instability,” Mishkin said.
According to Mishkin, financial history follows a typical chain of events:
Exuberant expectations rise about economic prospects or structural changes in financial markets, a credit boom begins, increasing the demand for some assets, thereby raising their prices.
The rise in asset values, in turn, encourages further lending against these assets, increasing demand, and hence prices, even more. This feedback loop can generate a bubble, and the bubble can cause credit standards to ease.
Eventually, “the bubble bursts,” Mishkin said.
But, Mishkin says, not all asset bubbles create massive risks for the financial system.
“In most cases, monetary policy should not respond to asset prices per se, but rather to changes in the outlook for inflation and aggregate demand resulting from asset price movements,” said Mishkin.
“This point of view implies that actions, such as attempting to prick an asset price bubble, should be avoided.”
Mishkin notes that the Fed does not have a crystal ball that can discern when an asset price bubble is good and when it is not so good.
“Asset price bubbles can be hard to identify,” said Mishkin. “Tightening monetary policy to restrain a bubble that has been misidentified can lead to weaker economic growth than is warranted.”
What is more, Mishkin said, the impact of interest rates on asset price bubbles is “highly uncertain.”
Market players are expecting to see high rates of return during a bubble and may not be dissuaded quickly from recalibrating their expectations by rising interest rates, the Fed governor said.
Other economic observers were somewhat taken aback by Mishkin’s comments.
“He seems to say that monetary policy is simply the setting of short-term, overnight interest rates,” Timothy A. Canova, an international monetary policy expert at the Chapman University School of Law, tells Moneynews.
“Free market ideology gets in the way of sensible regulation.”
Peter S. Cohan, a business professor at Babson College, told Moneynews, that the “laissez faire attitude” toward asset bubbles has spurred trillions of dollars of losses for U.S. and global investors.
“The Fed should get more involved in stopping future asset bubbles,” said Cohan.
But, Mishkin noted, the Fed’s intervention in the market during the Roaring Twenties failed miserably.
The stock market collapsed in October 1929 despite months of interest-rate tightening by the Fed.
“The Federal Reserve’s mistake in attempting to burst the bubble directly was made worse by its refusal to change course rapidly after the market collapsed and the banking system got into trouble,” said Mishkin.
“That allowed deflation to set in, which raised real interest rates to extremely high levels and further depressed growth.”
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