Wednesday, April 07, 2010

NY Fed's Dudley: Fed should take "proactive approach" to Asset Bubbles

by Calculated Risk on 4/07/2010 12:15:00 PM

The Fed's previous view was bubbles were hard to identify and the Fed's role was to clean up after a collapse. Now that view is changing ...

From NY Fed President William Dudley: Asset Bubbles and the Implications for Central Bank Policy

... Today I want to tackle a difficult subject: How should central bankers deal with potential asset price bubbles. ...

As I see it, we need to reexamine how central banks should respond to potential asset bubbles. After all, recent experience has underscored the fact that poorly regulated financial systems are prone to such bubbles and that the costs of waiting to respond to an asset bubble until after it has burst can be very high.

Today, I will try to define some of the important characteristics of asset price bubbles. I will argue that bubbles do exist and that bubbles typically occur after an innovation that has created uncertainty about fundamental valuations. This has two important implications. First, a bubble is difficult to discern and, second, each bubble has unique characteristics. This implies that a rules-based approach to bubbles is likely to be ineffective and that tackling bubbles to diminish their potential to destabilize the financial system requires judgment.

Despite the fact that it is hard to discern bubbles, especially in their early stages, I conclude that uncertainty is not grounds for inaction.
Dudley discusses the stock market and housing bubbles and the various tool available to the Fed to lean again the bubbles, and then concludes:
In my view, a proactive approach is appropriate when three conditions are satisfied: First, circumstances should suggest that there is a meaningful risk of a future asset price crash that could threaten financial stability. Second, we have identified tools that might have a reasonable chance of success in averting such an outcome. Third, we are reasonably confident that the costs of using the tools are likely to be outweighed by the benefits from averting the prospective crash. When these three conditions are satisfied, we should be willing to act.