While Congress has tasked the Federal Reserve with a set of specific objectives, these are ultimately aimed at creating a stable monetary environment in order to achieve overall economic stability. While the Fed is concerned about rapid inflation of general consumer prices, its preferred measure of inflation, the personal consumption expenditures (PCE), excludes asset prices.

Sometimes asset prices can get out of control, forming massive bubbles that when finally burst, have severe consequences for economic stability.  Some would argue the Fed should actively try to deflate such bubbles or to keep them from forming to maintain stability. However, while the Fed should be concerned, monetary policy is not the best tool to deal with asset bubbles. That, however, doesn’t mean nothing can be done.

Asset Price Bubble Examples

An asset bubble is a phenomenon in which asset prices deviate from fundamental values, usually because of exaggerated expectations of future growth. The rising price of the asset creates a feedback loop whereby speculative investors hope to profit from the price trend thus reinforcing the trends movement. At some point the bubble loses its momentum and panic sets in, leading to a steep reversal in the price trend; in other words, the bursting of the bubble. Two recent examples of asset price bubbles are the dot-com bubble and the subprime mortgage bubble.

The growing use of the internet during the late 1990s and the abundance of venture capital funding for startups were two factors that helped fuel a bubble in equity markets for information technology assets. Between 1995 and 2000 the technology-dominated Nasdaq index rose around 4,000 points reaching a peak on March 10, 2000, of 5132.52. About two and a half years later, the index had lost 78% of its value. While the burst of the dot-com bubble saw the U.S. economy slip into a recession starting in 2001, its effects were nothing compared to the bursting of the subprime mortgage bubble in 2007.

The Fed’s monetary stimulus that saw interest rates fall to historic lows following the bursting of the dot-com bubble helped to fuel a U.S. housing boom. As home prices began soaring nobody wanted to be left behind, and a new class of mortgages was extended to less than optimal homebuyers who did not qualify for traditional loans. Investment firms, eager to capitalize on the housing trend, bought these subprime mortgages and repackaged them as mortgage-backed securities (MBSs).

These securities were only as good as the debtors’ ability to pay, and when some mortgage defaults began to take place in 2007, the value of MBSs began to plunge. The asset side of banks’ balance sheets was being decimated by these falling securities prices causing many banks to declare bankruptcy, creating enormous financial instability and the worst recession since the Great Depression. (To read more, see: The Greatest Market Crashes).

What Can and Should the Fed do about Bubbles?

As asset price bubbles can have severe destabilizing effects on the economy, it would seem prudent that the Federal Reserve aim to do something about them. However, the primary argument against deliberately trying to do anything is that asset price bubbles are extremely hard to identify; some would even say impossible. Actions to deflate a misidentified bubble could end up causing more harm than good.

This, however, does not mean that the Fed should not bother trying to identify asset price bubbles, and when reasonably sure that one exists, do something about it. To be sure, using monetary policy by affecting short-term interest rates is not the best tool to attempt deflating a bubble. Some research suggests that the historical record indicates that bubbles are not all that sensitive to the level of short-term interest rates. Other research suggests that raising interest rates to deflate a bubble could cause its bursting to be much more severe than it otherwise would be.

Nevertheless, there is at least one action the Fed can take, and other actions that Congress could take. The Fed could use the bully pulpit to issue cautionary statements when there is a perceived bubble. This would hopefully deflate some of the irrational optimism that is helping to fuel the bubble.

Congress, on the other hand, could implement measures to improve the regulatory and supervisory framework that discourages asset price bubbles. Regulations that limit loan-to-value ratios, leverage, and higher lending standards would help to remove some of the steam that can fuel bubbles. (To read more, see: New Rules To Protect The World’s Banking System).

The Bottom Line

Asset price bubbles can have some devastating consequences for economic stability. No doubt, the Fed should be concerned when it believes a bubble is forming, but monetary policy is not the best tool to deal with such phenomena. The Fed should be ready to issue cautionary warnings, but it is up to Congress to provide a stable regulatory and supervisory environment to discourage the formation of asset bubbles.

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.