If a central bank’s financial stabilization policy is designed simply to smooth out fluctuations in asset prices, it runs the risk of delaying necessary price adjustments and creating substantial inefficiencies in the marketplace. Financial stabilization policies, if misapplied, can effectively subsidize risk-taking by systemically important financial institutions. Such policies run the risk of increasing moral hazard and ultimately raise the risk of systemic instability rather than lowering it.

To be clear, I think that 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. This point of view implies that actions, such as attempting to "prick" an asset price bubble, should be avoided.

I take this view for (at least) three important reasons.¹⁰ First, asset price bubbles can be hard to identify. As a result, tightening monetary policy to restrain a bubble that has been misidentified can lead to weaker economic growth than is warranted...

Second, even if asset price bubbles could be identified, the effect of interest rates on asset price bubbles is highly uncertain... Another way of saying this is that bubbles are departures from normal behavior, and it is unrealistic to expect that the usual tools of monetary policy will be effective in abnormal conditions...

Third, there are many asset prices, and at any one time a bubble may be present in only a fraction of assets. Monetary policy actions are a very blunt instrument in such a case, as such actions would be likely to affect asset prices in general, rather than solely those in a bubble.

Finally, our most powerful tool for addressing a liquidity crisis is monetary policy. In setting the stance of monetary policy, the Fed has a dual mandate: to help foster maximum employment and price stability. Monetary policy is concerned with mitigating financial market stress to the extent that the stress impedes fulfillment of this dual mandate. Broadly speaking, I see our response to a financial shock as similar to our approach for responding to other shocks to the economy: We gauge the most likely effects of the shock on the future paths for economic activity and inflation; we discuss less likely but more costly alternative outcomes that we may want to insure against; and, based on this analysis, we adjust policy to best fulfill our dual mandate.

``There are still issues with regard to asset-backed commercial paper,'' said Fisher, who doesn't vote on rates this year. ``It's the not the Federal Reserve's job to engineer asset prices. Our job is to keep the economy growing at a sustainable rate of growth without incurring inflation. That's what guides us in our discussions at the table.''

From the Q&A session, as reported by Bloomberg News

Central bankers have one instrument (the policy rate) and changes in that instrument are likely to affect other assets, not just the one whose price is rising rapidly. In the U.S., house prices and stock prices do not necessarily move in tandem. Yet, preemptively raising the fed funds rate to slow a rise in house prices may affect the stock market and other assets, not just the housing market. By focusing excessive attention on one sector or asset, the law of unintended consequences may raise its ugly head, resulting in more economic harm than good.

Excessive attention to the price behavior of a particular asset or asset class sends confusing and potentially misleading messages to the public. Will the public come to expect the central bank to implicitly place a ceiling on rates of return on certain assets, to the exclusion of its other stated goals? Undermining the credibility of the central bank’s commitment to price stability would complicate and raise the costs of achieving that goal. Hence, I view it as unwise to single out the price of houses, or any other item, for special consideration in conducting monetary policy.

Monetary policy, or the short-term interest rate, is not a good tool for leaning against or trying to pop asset price bubbles for a variety of reasons, including the fact that it is very difficult for us to know when an asset price is in a bubble; it’s very hard to know how the asset price would react to increases in interest rates; it’s hard to know what to do when some asset prices might be in bubbles and others not; it’s a concern what would happen to the real economy if you raise interest rates a lot to pop a bubble and the higher interest rates have adverse effects on the real economy. So there a lot of unknowns and uncertainties that make me very cautious and conservative about thinking about using monetary policy to address asset prices.

Some have espoused the view that central banks should go further—tightening monetary policy to dampen overly euphoric asset markets—to prick asset price bubbles before they burst. I do not espouse that view because it is exceptionally difficult to distinguish “bubbles” from fundamental-based booms and monetary actions impose certain short-run costs for very uncertain future gains. I therefore believe that central banks should stand ready to act to cushion the economy in response to shocks when and if they occur.

It is now the consensus of most practicing central bankers that monetary policy can’t do much preemptively to correct an existing substantial asset price misalignment. But if monetary policy is calibrated appropriately to keep aggregate demand growing roughly in balance with aggregate supply and to keep inflation low and stable, this reduces the risk that such misalignments will emerge and expand.

A special role for asset prices in the conduct of monetary policy requires three key assumptions. First, one must assume that a central bank can identify a bubble in progress... A second assumption needed to justify a special role for asset prices is that monetary policy cannot appropriately deal with the consequences of a burst bubble, and so preemptive actions against a bubble are needed... A third assumption needed to justify a special focus on asset prices in the conduct of monetary policy is that a central bank actually knows the appropriate monetary policy to deflate a bubble Because I doubt that any of the three assumptions needed to justify a special monetary policy focus on asset prices holds up, I am in the camp of those who argue that monetary policy makers should restrict their efforts to achieving their dual mandate of stabilizing inflation and employment and should not alter policy to have preemptive effects on asset prices.

[T]here is a further reason why I believe that a central bank should not put too much focus on asset prices. Such a focus can weaken its public support, making it harder for it to successfully conduct monetary policy to stabilize inflation and employment.

A central bank that focuses intently on asset prices looks as if it is trying to control too many elements of the economy. Part of the recent successes of central banks throughout the world has been that they have narrowed their focus and have more actively communicated what they can and cannot do. Specifically, central banks have argued that they are less capable of controlling real economic trends in the long run and should therefore focus more on price stability and damping short-term economic fluctuations. By narrowing their focus, central banks in recent years have been able to increase public support for their independence. A central bank that expanded its focus to asset prices could potentially weaken its public support and may even cause the public to worry that it is too powerful and has undue influence over all aspects of the economy.

My final observation is that all of this acquires greater significance at the current juncture. The world economy has been experiencing, and may now be emerging from, an unusually long period of historically low inflation-adjusted policy interest rates, unusually strong expansion in global liquidity, exceptionally buoyant asset prices, and strong global growth. And this has occurred at a time when globalisation should, if anything, have raised the world's natural interest rate, by boosting global growth potential while helping to keep a lid on inflation. But just because inflation has remained remarkably quiescent so far, should we assume that all is fine?

I say this in that spirit of humility which should underpin all policies. We must always remain alert and avoid complacency. The major policy mistakes in history that I highlighted earlier were made precisely when policymakers felt they had finally come to master the secrets of the economy. Preserving macroeconomic and with it, financial stability, is essential. We should not forget that it was financial stress at the core of the global economy, and its international ramifications, that proved fatal to the first wave of globalisation. I certainly do not have the answers. But these questions are worth asking.

From a comment on a paper by Frederic Mishkin on the benefits of globalization and the need for emerging markets to embrace more open capital markets

Although the data are suggestive, tests based on asset pricing models have not firmly established an empirical link between reduced macroeconomic volatility and higher asset prices. The ability to establish such a link is limited, in part because many of the fundamental concepts underlying asset prices, such as risk aversion and expected volatility of growth, are difficult to measure and the model outcomes depend greatly on assumptions regarding these key variables.

Without targeting asset prices, we need to be more attentive now to financial markets because asset prices affect spending to a greater degree than before and because asset prices provide us with a greater amount of timely information to guide policy. Moreover, we have become an even more receptive audience for research that enables us to better understand the links between the real economy and financial asset prices.

Debates on the relative merits of asset price targeting also will continue and possibly intensify in the years ahead...But given our current state of knowledge, I find it difficult to envision central banks successfully targeting asset prices any time soon. However, I certainly do not rule out that future work could improve our understanding of asset price behavior, and with it, the conduct of monetary policy.