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By Craig Torres and Vivien Lou Chen
Federal Reserve officials may be rethinking their aversion to acting against asset-price bubbles, an article of faith during former Chairman Alan Greenspan's 18 years at the helm.
After this month's near-collapse of Bear Stearns Cos., Minneapolis Fed Bank President Gary Stern -- the longest-serving policy maker -- said in a speech yesterday that it's possible ``to build support'' for practices ``designed to prevent excesses.'' New York Fed President Timothy Geithner, whose district bank took on almost $30 billion of Bear Stearns assets to rescue the firm, argued two years ago for a larger role for asset prices in decision-making, and there's no indication his views have changed.
For Fed policy makers, ``the consequences of their permissiveness have become so disastrous that they simply can't keep singing the same old tune in public,'' said Tom Schlesinger, executive director at the Financial Markets Center in Howardsville, Virginia.
While the soul-searching is unlikely to result in immediate changes to monetary policy, Stern's comments show how the credit freeze has forced officials to scrutinize long-held philosophies about the Fed's role in markets, and even ask how their current policies may undercut those views.
``As a risk manager, the Fed needs to take account of both directions, not just dealing with the aftermath,'' said Bruce Kasman, chief economist at JPMorgan Chase & Co. in New York. ``We have had two asset-prices bubbles in the last 10 years that have had big implications for the Fed's desire for a more stable macroeconomy.''
Stern's Reflection
Stern, 63, has been president of the Minneapolis Fed since 1985 and is currently a voting member of the rate-setting Federal Open Market Committee. In his speech to the European Economics and Financial Centre in London yesterday, he said that ``while I have not yet changed my opinion that asset-price levels should not be an objective of monetary policy, I am reviewing this conclusion in the wake of the fallout from the decline in house prices and from the earlier collapse of prices of technology stocks.''
He added that ``it is well within the realm of possibility for policy makers to build support for, and at least obtain tolerance of, policies designed to address excesses.''
Fed officials have spent years wrestling with how to prevent bubbles without damaging the economy through high interest rates, and few have come up with an answer. That's partly because the debate focused on use of the main policy rate instead of regulatory tools.
Greenspan Philosophy
For two decades, the ruling philosophy has been Greenspan's. ``It is far from obvious that bubbles, even if identified early, can be pre-empted at a lower cost than a substantial economic contraction and possible financial destabilization,'' Greenspan told the American Economic Association in 2004.
``I have always said if we could defuse a nascent asset bubble, I would be all for it,'' Greenspan, 82, said in an e- mailed response to a question yesterday. ``The reason I am against is that in my experience it cannot be done. I know of no occasion when such actions have been successful.''
But his successor, Ben S. Bernanke, and his team now find themselves reconsidering their approach to everything from regulation to the fate of the world's largest securities dealers. The collapse of the U.S. subprime-mortgage market has led to $208 billion in writedowns and credit losses since the start of 2007, pushing Bear to the brink of bankruptcy before its purchase by JPMorgan.
In his public remarks, Bernanke, 54, has opposed using interest rates to rein in asset prices, favoring keeping the benchmark rate focused on managing growth and inflation.
Role For Regulation
At the same time, he does see a role for regulations to reduce the likelihood of bubbles and protect institutions when they pop. He is also open to using other tools, as his response to the seven-month credit crisis has shown. And if the Fed gets more supervisory responsibility for securities firms, officials are likely to take more interest in policies that can discipline markets and balance incentives, economists said.
``If it is the case that asset prices matter for the intermediation of credit, then they have to worry about it,'' said Vincent Reinhart, former director of the Fed's Monetary Affairs Division, and now a scholar at the American Enterprise Institute in Washington.
The Fed has cut the benchmark rate 2 percentage points this year, the fastest pace in two decades. Bernanke has also changed the composition of the Fed balance sheet, absorbing more mortgage bonds, and swapping Treasuries for even private-label and commercial mortgage-backed securities, in effect influencing prices of securities tied to housing.
Bailout `Hazards'
Stern has spoken publicly only seven times in the last year. The Minneapolis president co-authored a 2004 book called ``Too Big to Fail: the Hazards of Bank Bailouts,'' which concluded that while governments shouldn't avoid public support for creditors of failing banks, they should minimize that backing because of the distortions it produces.
``If someone like that, steeped in the Fed's traditions, opens the door to a new or different approach to policy, we have to take it seriously,'' said Robert McTeer, a former president of the Dallas Fed.
To contact the reporter on this story: Vivien Lou Chen in San Francisco at vchen1@bloomberg.net
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