In case you missed the fine coverage of this at Calculated Risk and at Institutional Economics, this is interesting commentary on Fed policy regarding bubbles (if bubbles exist) by Glenn Rudebusch, a researcher with the San Francisco Fed, based upon this FRBSF Economic Letter. This recent post is also about bubble (resource misallocation) policy and complements Rudebusch’s remarks:
Fed May Need to Raise Rates to Stop 'Bubbles,' Researcher Says, Bloomberg: U.S. central bankers may need to consider raising interest rates to keep surging property prices from creating a financial crisis or a long-term economic slowdown, a researcher with the Federal Reserve Bank of San Francisco said. ''While there are hurdles to clear, the door may be open for using higher interest rates to help reduce or contain price bubbles,'' Glenn Rudebusch, the bank's associate research director, said in an interview Aug. 12.
Rudebusch's comments go beyond the stance taken by Fed Chairman Alan Greenspan and the rest of the Federal Open Market Committee, which decided at its June meeting not to use higher rates to address "possible mispricing'' of assets … Greenspan "has stated his view and thinks it is delusional to think monetary policy is a good tool for popping asset price bubbles,'' Rudebusch said. ''There's still a lot of research to be done and it's not an open-and-shut case.'' … Greenspan told Congress in testimony earlier this year that while there was "froth'' in some local real estate markets, there probably isn't a nationwide bubble in home prices. … Policy makers, in theory, have two choices when asset prices rise in a way that may reflect ''price speculation or irrational investor euphoria,'' Rudebusch said in an Aug. 5 letter posted on the bank's Web site. One is a ''standard policy'' that uses higher rates to offset increased inflation pressures and rising consumer demand that might be triggered, for example, by a booming stock market, he said. The other is a ''bubble policy'' that goes further and tries to reduce the size of the bubble by setting interest rates ''even higher.'' Some surging asset prices may hurt the economy in a way that's difficult to undo, he said. The dot-com bubble, for instance, ''spurred overinvestment in fiber-optic cable and decimated the provision of venture capital for new technology startups for years.''
Central bankers need to answer three questions before taking a bubble policy approach, Rudebusch said. The first is whether a bubble can be identified. Another is whether the fallout from such a bubble will be significant and hard to correct later. The third is whether interest rates are the best tool for addressing rising asset prices. … Rudebusch said ''there is no bottom line on the appropriate policy response to asset price bubbles.'' Further research and experience are needed to settle the debate, he said.