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FRB Speech, Bernanke -- Asset-price "bubbles" and monetary policy: October 15, 2002: My talk today will address a contentious issue, summarized by the following pair of questions: Can the Federal Reserve (or any central bank) reliably identify "bubbles" in the prices of some classes of assets, such as equities and real estate? And, if it can, what if anything should it do about them?...
As a preliminary to assessing the critics' argument, and to get my own views on the table right away, let me briefly sketch a policy framework that I believe is useful for thinking about these issues.... My suggested framework for Fed policy regarding asset-market instability can be summarized by the adage, Use the right tool for the job.... The Fed likewise has two broad sets of policy tools: It makes monetary policy, which today we think of primarily in terms of the setting of the overnight interest rate, the federal funds rate. And, second, the Fed has a range of powers with respect to financial institutions, including rule-making powers, supervisory oversight, and a lender-of-last resort function made operational by the Fed's ability to lend through its discount window. By using the right tool for the job, I mean that, as a general rule, the Fed will do best by focusing its monetary policy instruments on achieving its macro goals--price stability and maximum sustainable employment--while using its regulatory, supervisory, and lender-of-last resort powers to help ensure financial stability....
[T]he Fed should ensure that financial institutions and markets are well prepared for the contingency of a large shock to asset prices... banks be well capitalized and well diversified... contribute to reducing the probability of boom-and-bust cycles... more-transparent accounting and disclosure practices... financial literacy and competence... integrity of the financial infrastructure--in particular, the payments system....
As I noted at the beginning, however, the framework just articulated is not universally accepted, particularly the aspect that precludes attempts to guide the course of asset prices. Instead, a number of critics have argued that monetary policy should be more proactive in trying to correct incipient "imbalances" in asset markets.... Aggressive bubble-poppers would like to see the Fed raise interest rates vigorously and proactively to eliminate potential bubbles in asset prices. To be frank, this recommendation concerns me greatly, and I hope to persuade you that it is antithetical to time-tested principles and sound practices of central banking.... [T]he Fed cannot reliably identify bubbles in asset prices... monetary policy is far too blunt a tool for effective use against them.... I worry about the effects on the long-run stability and efficiency of our financial system if the Fed attempts to substitute its judgments for those of the market. Such a regime would only increase the unhealthy tendency of investors to pay more attention to rumors about policymakers' attitudes than to the economic fundamentals....
A truly vigorous attempt by a central bank to rein in a supposed speculative bubble may well succeed but only at the risk of throttling a legitimate economic boom or, worse, throwing the whole economy into depression.....
[T]he stock market was as much a victim as a cause of the Depression... the stock market boom of the 1920s was surprisingly hard to kill. Indeed, stock prices did not collapse in 1929 but only began to plummet when the depth of the general economic decline became apparent.... The correct interpretation of the 1920s, then, is not the popular one--that the stock market got overvalued, crashed, and caused a Great Depression. The true story is that monetary policy tried overzealously to stop the rise in stock prices. But the main effect of the tight monetary policy, as Benjamin Strong had predicted, was to slow the economy--both domestically and, through the workings of the gold standard, abroad. The slowing economy, together with rising interest rates, was in turn a major factor in precipitating the stock market crash. This interpretation of the events of the late 1920s is shared by the most knowledgeable students of the period, including Keynes, Friedman and Schwartz, and other leading scholars of both the Depression era and today.... The Federal Reserve went on to make a number of serious additional mistakes that deepened and extended the Great Depression of the 1930s... little or no effort to protect the banking system from depositor runs and panics... permitted a severe deflation....
Even putting aside the great difficulty of identifying bubbles in asset prices, monetary policy cannot be directed finely enough to guide asset prices without risking severe collateral damage to the economy.
A far better approach... supervisory action to ensure capital adequacy in the banking system, stress-testing of portfolios, increased transparency in accounting and disclosure practices, improved financial literacy, greater care in the process of financial liberalization, and a willingness to play the role of lender of last resort when needed...
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