I think it's incompatible with a market economy to have a government agency setting asset prices.

Under the rubric of risk management are a number of specific issues that we at the Fed had to address over the past decade and a half and that will likely resurface to confront future monetary policymakers.

Most prominent is the appropriate role of asset prices in policy. In addition to the narrower issue of product price stability, asset prices will remain high on the research agenda of central banks for years to come. As the ratios of gross liabilities and gross assets to GDP continue to rise, owing to expanding domestic and international financial intermediation, the visibility of asset prices relative to product prices will itself rise. There is little dispute that the prices of stocks, bonds, homes, real estate, and exchange rates affect GDP. But most central banks have chosen, at least to date, not to view asset prices as targets of policy, but as economic variables to be considered through the prism of the policy's ultimate objective.

Can central bank talk--Fedspeak, in the vernacular of the U.S. media and financial markets--make monetary policy more effective and improve economic outcomes? To see why communication may be an integral part of good monetary policymaking, recall that the Federal Reserve directly controls only a single short-term interest rate, the overnight federal funds rate. Relative to the enormous size of global financial markets, the market for federal funds--the market in which commercial banks borrow and lend reserves on a short-term basis--is insignificant. Control of the federal funds rate is therefore useful only to the extent that it can be used as a lever to influence more important asset prices and yields--stock prices, government and corporate bond yields, mortgage rates--which in turn allow the Fed to affect the overall course of the economy.

It should not be too surprising, then, that the Federal Reserve’s response to the Asian financial crisis, like the response to the 1987 stock market crash, was to provide liquidity through open market operations by lowering the federal funds rate target rather than by using the discount window. However, using open market operations rather than the discount window has potential implications for the overall stance of monetary policy. When the Federal Reserve provided extended credit to the banking system in the 1980s and early 1990s, discount window borrowing was generally offset by open market operations to keep overall liquidity in the banking system unchanged. As a result, the stance of monetary policy was kept independent of liquidity provision via the discount window.

In contrast, when the Federal Reserve uses open market operations without the discount window, the stance of monetary policy is changed. This raises two concerns. First, what if the appropriate monetary policy stance conflicts with the need to provide liquidity to individual institutions or to financial markets? Second, if open market operations are used to provide additional liquidity in times of crisis, when is the appropriate time to remove this liquidity to prevent a buildup of inflationary pressures? These are important questions deserving further research and analysis.

Normally, I would agree with Bill Poole about intermeeting moves. I don’t think it’s a good idea to count on them very often. But the interval between our March 20th and May 15th meetings is a long one and we know, as does everybody else, that we’re probably going to cut rates further. To delay that gives a rather perverse incentive to the market that makes it more attractive to sell stocks in order to buy bonds. While I accept your point that it would be desirable for the stock market to get its legs on its own and not through action by the Federal Reserve, there is another thing to consider. And that is that we have just had two days of really good stock market performance.

So if we were to cut the target funds rate today, we couldn’t be accused of doing so because of the stock market. Later in this 10-day window, that may not be the case. We may get to the point where we want to cut the rate in the next 10 days and the stock market environment will make the Greenspan “put” come alive again. So, I was disappointed to hear that you didn’t want to make a move today. I think we really should cut the funds rate today.

I just wanted to make a very simple point that should be obvious but that I suspect is not--that there is a form of asymmetry in response to asset rises and asset declines but not if the rate of change is similar.  In other words, central banks do not respond to gradually declining asset prices.  We do not respond to gradually rising asset prices.  We do respond to sharply reduced asset prices, which will create a seizing up of liquidity in the system.  But you almost never have the type of 180-degree version of the seizing up on the up side. If, indeed, such an event occurred, I think we would respond to it.  The actuality is that it almost never occurs, so it appears as though we are asymmetric when, indeed, we are not. The markets are asymmetric; we are not.

[T]he central bank cannot effectively directly target stock or other asset prices. Should an asset bubble arise, or even if one is already in train, monetary policy properly calibrated can doubtless mitigate at least part of the impact on the economy. And, obviously, if we could find a way to prevent or deflate emerging bubbles, we would be better off. But identifying a bubble in the process of inflating may be among the most formidable challenges confronting a central bank, pitting its own assessment of fundamentals against the combined judgment of millions of investors.

...The danger is that in these circumstances, an unwarranted, perhaps euphoric, extension of recent developments can drive equity prices to levels that are unsupportable even if risks in the future become relatively small. Such straying above fundamentals could create problems for our economy when the inevitable adjustment occurs. It is the job of economic policymakers to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion.