Should central banks attempt to deflate asset price bubbles before they get big enough to cause big problems? Until recently, most central bankers would have said no. They would have argued that policy should focus solely on inflation, employment, and output goals—even in the midst of an apparent asset-price bubble. That was the view that prevailed during the tech stock bubble and I myself have supported this approach in the past. However, now that we face the tangible and tragic consequences of the bursting of the house price bubble, I think it is time to take another look.

I would not advocate making it a regular practice to use monetary policy to lean against asset price bubbles. However recent experience has made me more open to action. I can now imagine circumstances that would justify leaning against a bubble with tighter monetary policy. Clearly further research may help clarify these issues.

Nonetheless, even if policymakers are confident that a bubble has emerged, the question of the timeliness of the call remains.  The essential problem is the timing of the detection of the bubble relative to the timing of its collapse.  The risk is that the detection and subsequent policy response occurs not long before the bubble collapses on its own.  Given the lags associated with monetary policy, the resulting contractionary effects on the economy of the monetary tightening would occur just when the adverse effects of the bubble's collapse are being realized, worsening rather than mitigating the effects of the bubble's collapse.  And the inevitable lags in detecting bubbles increases the likelihood that, by the time action is taken, speculative activity will have progressed to the point that its collapse is not far off. 

The likelihood of deflation, "whatever I thought that risk was four or five months ago, I think it's bigger now, even if it's still small," he said.   But, "A lesson I take from the Japanese experience is not to let that get ahead of us, to be aggressive in moving against that risk if we see it coming," Kohn said, responding to questions following a speech to the Cato Institute's 26th Annual Monetary Policy Conference 

While "some people have argued that we should save our ammunition, that interest rate cuts aren't effective, etcetera, I think that were we to see this possibility that we should be very aggressive with our monetary policy, as aggressive as we can be," Kohn said.   

From the audience Q&A, as reported by Market News

The proximate cause of the financial turmoil was the steep increase and subsequent decline of house prices nationwide, which, together with poor lending practices, have led to large losses on mortgages and mortgage-related instruments by a wide range of institutions.  More fundamentally, the turmoil is the aftermath of a credit boom characterized by underpricing of risk, excessive leverage, and an increasing reliance on complex and opaque financial instruments that have proved to be fragile under stress.

While policymakers have acknowledged that asset price excesses and their subsequent correction can potentially have meaningful consequences for the economy, they generally have preferred to try to cushion the repercussions of an asset price collapse rather than to address an asset price run-up in its early stages. There are, to be sure, good reasons for this attitude, having to do with the difficulty of identifying asset 'bubbles' in a timely way, the need to build public support for action, and the challenge of weighing the costs and benefits of action for the broad economy. Nevertheless, in view of the damage resulting from the decline in housing values, as well as the aftermath of the collapse of prices of technology stocks earlier this decade, I think it essential to revisit these issues.

Identification of excesses in asset prices, although challenging, does not appear to be beyond the realm of possibility. There is some work in academic circles, and at least some practitioners agree, that when common ratios (the ratio of stock prices to earnings or dividends, for example, or the ratio of housing values to rents) exceed the bounds of historical experience, it is likely that a price correction will follow, although its timing is unpredictable. It would seem likely that misidentification will occur occasionally and, in particular, that some events may be classified as bubbles when they are not.  The implication of this possibility is, in my view, to ensure that the policy response to a perceived excess in asset prices is measured, so that even if in error the ramifications for the economy will be modest.

This consideration illustrates, perhaps, the critical issue in addressing asset price excesses. When all is said and done, will the benefits outweigh the costs, assuming policymakers have made the correct identification? Monetary policy, for which we in the Federal Reserve are responsible, is a blunt instrument with economy-wide effects. We should not pretend that actions taken to rein in those asset price increases which seemingly outstrip economic fundamentals won't in the short run curtail to some extent economic growth and employment; after all, such actions are likely to require raising interest rates earlier and probably more than otherwise would be the case.

[O]bviously, the last decade has shown that bursting bubbles can be an extraordinarily dangerous and costly phenomenon for the economy, and there is no doubt that as we emerge from the financial crisis, we will all be looking at that issue and what can be done about it.

From the Q&A session, as reported by the Wall Street Journal

It's a tough, tough choice as a policy maker. It's always tempting to think, ``Well, I know where this is going to go, let's just smooth out the path and get it there.'' Or to come to the judgment that things are overshooting and they've really gone too far. But I tend to have some respect for market processes in times like this. And I like to approach this with some humility about policy makers' ability to asses where mortgage backed securities should trade, just as we were genuinely humble about what we could say about where tech stocks should trade through.

"No government, no central bank can be indifferent to changes in the value of its currency," Geithner said.

He said the dollar was important not just because of its effect on growth and inflation in the U.S. and elsewhere but also because of "the very important role" it plays in the international financial system.

Geithner added: "As a result, as you would expect, we pay very close attention to what happens in (foreign) exchange markets."

During audience Q&A, as reported by Reuters

Consistent with Munger's admonition, the Fed saw it necessary to expand our toolkit beyond the proverbial hammer of the policy rate in the last nine months. And as I discussed in remarks last month, the Fed's nontraditional policy response included the use of innovative liquidity tools to counter the market turmoil and improve the functioning of financial and credit markets.⁴

In my remarks today, I would like to discuss the use of the hammer--the setting of the federal funds rate--particularly in extraordinary times. Of course, determining the proper level of the federal funds rate is rarely simple, given typical imprecision on key economic variables and relationships. It is far more challenging still when the financial architecture is in the early stages of redesign, the economy is adjusting to the aftermath of a credit bubble (witnessed most acutely in the housing markets), and inflation risks are evident.

The Federal Reserve has employed the hammer with considerable force in the last nine months, lowering the federal funds rate by 3-1/4 percentage points, with wide-ranging implications for the economy. Of substantial import, we have filled the toolkit with other implements to provide liquidity and improve the provisioning of credit during the turmoil. But now, policymakers may be well served encouraging a new financial architecture to emerge, aided, in part, by the actions we have taken. Even if the economy were to weaken somewhat further, we should be inclined to resist expected, reflexive calls to trot out the hammer again.

Policy actions should reinforce the notion with stakeholders that further hammering needs to be done, but it needs to be accomplished by the financial institutions themselves in retooling their businesses and rebuilding the credit channel to help ensure a stronger, more durable economy.

In the extreme, the interaction between asset prices and the health of financial institutions following the collapse of an asset price bubble can endanger the operation of the financial system as a whole.⁶

To be clear, not all asset price bubbles create these risks to the financial system. For example, the bubble in technology stocks in the late 1990s was not fueled by a feedback loop between bank lending and rising equity values; indeed, the bursting of the tech-stock bubble was not accompanied by a marked deterioration in bank balance sheets. But potential for some asset price bubbles to create larger difficulties for the financial system than others implies that our regulatory framework should be designed to address the potential challenges to the financial system created by these bubbles.

Just as doctors take the Hippocratic oath to do no harm, central banks should recognize that trying to prick asset price bubbles using monetary policy is likely to do more harm than good.

Q:  Some of your colleagues have said that maybe it wasn’t wise to keep rates as low or for as long as the Fed’s policy committee did earlier this decade. Do you agree?

A:  It’s hard to separate what I think now from what I thought at the time. I think with the benefit of hindsight, rates may have stayed too low for too long. But if you put yourself back in that environment, don’t forget: There was concern about we were heading toward deflation … and that it might be very difficult to execute effective policy in that environment. We look to bring as much economic science to this as you can, but you’re always making judgments, there’s no getting around it.

Last week in San Antonio, I provided my perspective on the situation we now encounter in a marketplace entering the early stages of recovery from a period of excess, indiscriminate behavior and historical (and occasionally hysterical) amnesia, and on the efforts we at the Federal Reserve are making to calmly and prudently restore the efficacy of the financial markets. I said then—and I assert again today—that there is nothing “unprecedented” about the situation we find ourselves in.

The Fed has to be careful not to aggravate boom-bust cycles in monetary policy and the economy. We have to be somewhat cautious in our approach.

From press Q&A as reported by Market News International