Some have asserted that the Federal Reserve can deflate a stock-price bubble--rather painlessly--by boosting margin requirements. The evidence suggests otherwise. First, the amount of margin debt is small, having never amounted to more than about 1-3/4 percent of the market value of equities; moreover, even this figure overstates the amount of margin debt used to purchase stock, as such debt also finances short sales of equity and transactions in non-equity securities. Second, investors need not rely on margin debt to take a leveraged position in equities. They can borrow from other sources to buy stock. Or, they can purchase options, which will affect stock prices given the linkages across markets.

Thus, not surprisingly, the preponderance of research suggests that changes in margins are not an effective tool for reducing stock market volatility. It is possible that margin requirements inhibit very small investors whose access to other forms of credit is limited. If so, the only effect of increasing margin requirements is to price out of the market the very small investor without addressing the broader issue of stock price bubbles.

If a change in margin requirements were taken by investors as a signal that the central bank would soon tighten monetary policy enough to burst a bubble, then there might be the appearance of a causal effect. But it is the prospect of monetary policy action, not the margin increase, that should be viewed as the trigger. In a similar manner, history tells us that "jawboning" asset markets will be ineffective unless backed by action.

If the bursting of an asset bubble creates economic dislocation, then preventing bubbles might seem an attractive goal. But whether incipient bubbles can be detected in real time and whether, once detected, they can be defused without inadvertently precipitating still greater adverse consequences for the economy remain in doubt.

It may be useful, as a first step, to consider both the economic circumstances most likely to impede the development of bubbles and the circumstances most conducive to their formation. Destabilizing macroeconomic policies and poor economic performance are not likely to provide fertile ground for the optimism that usually accompanies surging asset prices.

Ironically, low inflation, economic stability, and low risk premiums may provide tinder for asset price speculation that could be sparked should technological innovations open up new opportunities for profitable investment. ...

The conditions of extended low inflation and low risk were combined with breakthrough technologies to produce the bubble of recent years. But do such conditions always produce a bubble? It seems improbable that a surge in innovation in the near future would generate a new bubble of substantial proportions. Investors are likely to be sensitive to the need for asset prices to be backed ultimately by an ongoing stream of earnings. Hence, a further necessary condition for the emergence of a bubble is the passage of sufficient time to erode the traumatic memories of earlier post-bubble experiences.

Most standard macroeconomic models fitted to the experience of recent decades imply that a distortion in valuation ratios induced by a bubble can be offset by adopting a sufficiently restrictive monetary policy...  But that conclusion is a consequence of the model's construction. It is not based on evidence drawn from history. In fact, history indicates that bubbles tend to deflate not gradually and linearly but suddenly, unpredictably, and often violently. In addition, the degree of monetary tightening that would be required to contain or offset a bubble of any substantial dimension appears to be so great as to risk an unacceptable amount of collateral damage to the wider economy...

...Among our realistically limited alternatives, dealing aggressively with the aftermath of a bubble appears the most likely to avert long-term damage to the economy. 

We at the Federal Reserve considered a number of issues related to asset bubbles--that is, surges in prices of assets to unsustainable levels. As events evolved, we recognized that, despite our suspicions, it was very difficult to definitively identify a bubble until after the fact--that is, when its bursting confirmed its existence.

From mid-1999 through May 2000, the federal funds rate was raised 150 basis points. However, equity price increases were largely undeterred during that period despite what now, in retrospect, was the exhausted tail of a bull market. Such data suggest that nothing short of a sharp increase in short-term rates that engenders a significant economic retrenchment is sufficient to check a nascent bubble. The notion that a well-timed incremental tightening could have been calibrated to prevent the late 1990s bubble is almost surely an illusion. Instead, we noted in the previously cited mid-1999 congressional testimony the need to focus on policies "to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion."

If equity premiums were redefined to include both the unrealistic part of profit projections and the unsustainably low segment of discount factors, and if we had associated measures of these concepts, we could employ this measure to infer emerging bubbles. That is, if we could substitute realistic projections of earnings and dividend growth, perhaps based on structural productivity growth and the behavior of the payout ratio, the residual equity premium might afford some evidence of a developing bubble. Of course, if the central bank had access to this information, so would private agents, rendering the development of bubbles highly unlikely.

Movements in asset prices most often reflect changing underlying fundamentals. Forecasts that an increase in an asset price is a bubble would likely run counter to the conventional wisdom of a large segment of the investment community, or asset prices would not be so high.

[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.

History demonstrates that participants in financial markets are susceptible to waves of optimism, which can in turn foster a general process of asset-price inflation that can feed through into markets for goods and services. Excessive optimism sows the seeds of its own reversal in the form of imbalances that tend to grow over time. When unwarranted expectations ultimately are not realized, the unwinding of these financial excesses can act to amplify a downturn in economic activity, much as they can amplify the upswing.

Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy?