Opinion pieces are supposed to be provocative, so kudos to Donald L. Luskin, chief investment officer at Trend Macrolytics LLC. His “op-ed” view published in today’s Wall Street Journal (“Can the Fed Identify Bubbles Before They Happen?”) does make one consider again the important issue of the Federal Reserve’s role in trying to rein in asset price increases that divorce from reality.
Luskin’s view (worth reading in its entirety) was widely accepted before the credit crisis and had the backing of former Fed Chairman Alan Greenspan and others. Essentially, it’s this: it’s not the Fed’s role to try to prick asset price bubbles as they are rising. The reasoning is two fold: the Fed has no unique insight into what’s a developing bubble and what’s not and if it employed traditional interest rate tools to stop a bubble, it likely would also derail the entire economy.
To this, Luskin adds a slippery slope argument. “If the Fed is to determine the price of the overall housing market, or stock market, or oil market, how is that different in principle from having it determine the price of every individual item at Wal-Mart of the salary of every individual who works there?”
Well, it’s a lot different to supply a monetary policy or even regulatory counterweight to a macro development such as a bubble in a deep and liquid market than installing a Fed employee at the check out counter of Wal-Mart. That quote also implies the Fed now doesn’t have a huge role in steering the economy. It does.
Full disclosure: this blogger in the past wrote in agreement with the hands-off, clean-up-after-the-mess approach for the Fed toward asset class bubbles. But the mess this time was just too large, too threatening to the world’s financial system, too costly in terms of a deep, global recession to carry on with that view.
‘I think that the crisis has demonstrated that the cost of waiting to clean up asset bubbles after they burst can be very high. That suggests we should explore how to respond earlier.” So said New York Federal Reserve President William C. Dudley in June, as quoted by Luskin. The “op-ed” author takes particular umbrage with Dudley’s views.
Yet Dudley’s position is a reasonable, post-crisis position and one that likely represents the newly formed attitude of more than just that one Fed policy maker. On June 18, Wall Street Journal reporter Jon Hilsenrath wrote: “The Fed also is examining whether it can do more to deflate financial bubbles before they get too big. For many years officials felt it was sufficient to clean up after a bubble burst – the idea has now been discredited.” And in a separate April article about Fed Vice Chairman Donald Kohn, Hilsenrath said the veteran Fed official was rethinking some issues, “including whether the Fed can do more to prevent bubbles …”
Luskin makes the good point that the Fed’s “track record reveals more skill at causing bubbles than preventing them …”
So the first thing the Fed should do is renew its version of the Hippocratic oath – first do no harm. Or, in Fed terms, have the courage to reassert its counter-cyclicality. They have to push against heady times (that now seems a distant memory) with aggressive policy actions.
The Fed may well need an expanded tool kit to deal with asset price bubbles and the record will necessarily be mixed. But sometimes someone has to lean against the wind and the Fed is best positioned to do so.