I don't intend this to be a big opus on the Fed and bubbles. I simply want to add my two-cents worth to what I keep hearing and, more importantly, not hearing about it on financial TV and radio.
As background, as Dallas Fed President, I served on the FOMC from February 1991 to November 2004, all that time under Alan Greenspan as Chairman. That period included the dot.com bubble and the beginning of the real-estate bubble.
There seems to be an almost unanimous consensus today that the Fed should have pricked both those bubbles early on and not have let them grow. I have heard no one mention, however, that the Fed had no mandate or legal authority to base monetary policy on bubbles.
We hear a lot these days about the Fed's dual mandate, price stability and sustainable economic growth, which were eventually distilled down from more than two. The principal one dropped along the way was balance in international payments, which came to be perceived as either automatic or irrelevant under floating exchange rates. With the exchange rate free to adjust, policy didn't have to.
In the old days-especially in the days of Texas populists on the House Banking Committee-the Fed was burdened greatly by a Congressional tug-of-war over its goals of price stability on the one hand and rapid growth and full employment on the other hand. Miraculously, there finally came a time when a critical mass of economists and politicians accepted the proposition that in the long run there was no real conflict between the two. The conflict was resolved by the acceptance or toleration of the proposition that price stability provided the best economic environment for sustainable growth. So, while both goals were important, price stability was both an ultimate goal and a precondition for the other ultimate goal.
At no time during these debates that I'm aware of was preventing or pricking bubbles considered a legitimate central bank goal. More importantly, it was not part of the Fed's mandate as set forth in the Federal Reserve Act, the Employment Act of 1946, or Humphrey-Hawkins. There was, and is, no legal basis for the Fed to make bubble busting an independent goal of monetary policy.
There was a general consensus among FOMC members in the late 1990s that the stock market boom was difficult to understand, especially after it continued strongly after the Chairman's Irrational Exuberance speech in 1996. Staff presentations generally had a correction somewhere in the future because they just couldn't rationalize the skyrocketing of the stock market, especially dot.com stocks. I don't recall the term "bubble" being used much, but that's neither here nor there.
What I do recall was Chairman Greenspan asking more than once during committee discussions something like "Who are we to put our judgment of appropriate stock prices ahead of millions of individual investors?" This sentiment was not expressed in the context of a debate on whether we should do something about stock prices. There was no such debate, although the subject of possible changes in margin requirements came up from time to time. The Chairman dismissed that on the grounds that they wouldn't be effective, that they would hurt small investors while large, more sophisticated, investors would find a way around them.
I remember very well my own thoughts on the subject. I imagined, if we were to tighten monetary policy to curb rising equity prices, what the announcement would have sounded like and what the public reaction would have been. I imagined a press release along the following lines:
"The FOMC met today [some day in the late 1990s], reviewed economic and financial conditions, and established policy for the coming period. Economic growth appeared strong, but sustainable, employment growth was robust, unemployment remained low, and inflation was continuing to moderate. In summary, the economy is performing better than it has in decades.
Despite good growth and low inflation, however, the committee concluded that monetary policy should be tightened because of the recent overly-rapid rise in equity prices. To curb the rise in the equity prices, the Committee decided to raise its target Federal funds rate by 50 basis points. The Committee also expressed its commitment to continue to monitor the situation closely and to stand ready to take further actions as necessary to bring rapid stock-price increases under control. It is the intention of the Committee to prevent a stock market bubble from forming."
How do you think that announcement would have been received, by the public, and by Congress?
When I retired in November 2004, Chairman Greenspan, as I recall, was still declining to use the word "bubble" to describe the then national real estate market. There may have been a few localized bubbles, but no national bubble. He thought "froth" might better describe the national situation while acknowledging that froth could be defined as many little bubbles.
But, "froth" versus "bubbles" was beside the point. The Fed had no mandate or legal authority to use monetary policy to limit house-price appreciation even if it had wanted to. It would only do so as part of a more generalized overheating of the economy that threatened an acceleration of inflation.
I was at the Jackson Hole meeting when Chairman Greenspan made his famous bubble speech-about how you really can't tell it's a bubble before it bursts, and how it's the job of the central bank to clean up afterward. This was after the dot.com bubble burst, but before the real-estate bubble had formed.
I found that to be a strange speech with a strange conclusion-not that I necessarily disagreed with its conclusion, but because I didn't know what purpose it served. Leaving aside the minor issues of no mandate from Congress and no legal authority, since it was made after the dot.com bubble burst, I doubt that he convinced his audience. It had the opposite effect on me, and I think the Chairman would have been better served not to bring it up.
The real-estate bubble needed some air let out before it popped, but if Congress wants the Fed to have bubble-popping responsibility in the future, it should say so. It should pass a law. (Did I say that?)
I don't necessarily agree that the Fed should have such a mandate, but, if we are going to hold it responsible for bubbles, Congress should say so before, rather than after, they pop. And, by the way, the legislation should include instructions on how to recognize them on Friday morning rather than Monday morning.