Federal Reserve Bank of New York President Dudley Calls for the Fed to Take Action Against Bubbles

Last Updated Apr 7, 2010 4:12 PM EDT

One of the stories making the rounds today is Federal Reserve bank of New York President William Dudley's call for the Fed to take action against bubbles:
Fed's Dudley Calls for Action on Bubbles, RTE: Federal Reserve Bank of New York President William Dudley said Wednesday the damage caused by financial market bubbles should bring about a sea change in the way the central bank acts, with the Fed needing to move toward active efforts to reign in financial market excess.
"There is little doubt that asset bubbles exist and they occur fairly frequently," and when they burst the economy frequently suffers, Dudley said. And while it can frequently be difficult to discern the existence of a financial market bubble, the problems these imbalances create means "uncertainty is not grounds for inaction" on the part of central bankers.
Dudley's view on asset bubbles comes as part of a broader re-evaluation of financial market bubbles by central bank officials. ...
I want to follow up on this point:
The official indicated interest rate policy is not the best tool to moderate a market that's running wild.

Because every bubble is its own beast, "a rules-based approach to bubbles is likely to be ineffective," Dudley warned. Instead, talking and regulation appear best suited to the task at hand. "Use of the bully pulpit and macro-prudential tools, such as rules limiting loan-to-value ratios or leverage, are likely to prove superior to monetary policy," Dudley said. ...
Dudley explained central bankers will find it challenging to discover whether they have a bubble on their hands, and that it will also be difficult to discern what tool is the right one for the job. Central bankers should also be prepared for the fact they may well make "mistakes"...
The central banker also reiterated that hiking rates to lean into a bubble is not the best way to roll, as such a move would have a "too broad" impact. ...
That's the point I want to emphasize: interest rate changes are a poor tool for managing apparent bubbles. If, say, there's a bubble that appears to be developing in the housing industry, an aggressive increase in interest rates can stop it, but it will also negatively affect every other business that relies on credit. This is because the interest rate hike increases the cost of borrowing. For this reason, regulation and oversight is likely to be a better tool, particularly oversight focused on the particular industry in question.

The other point I want to emphasize is one I've been making repeatedly lately. We shouldn't expect that the Fed or any other regulators will be successful in their attempt to identify and pop bubbles before they get so large they can cause severe damage. Despite our best efforts, troublesome bubbles are likely to appear again, then pop. The key is to make sure that when this happens the damage is contained to the extent possible (without unduly hindering financial markets during good times). This is where strict limits on leverage, credible resolution authority for large banks, capital requirements (perhaps varying with economic conditions), limits on connectedness, and other such policies can be helpful. I'm glad the Fed is going to try to stop bubbles before they grow large, a first line of defense is important, but the second line of defense -- attenuating the effects of a bubble -- is just as important, if not more so. From my perspective, not enough attention has been devoted to this aspect of regulation.

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