Asset Bubbles: Economic Effects and Policy Options for the Federal Reserve

Asset Bubbles: Economic Effects and Policy
Options for the Federal Reserve
Updated September 25, 2007
Marc Labonte
Specialist in Macroeconomics
Government and Finance Division

Asset Bubbles: Economic Effects and Policy Options
for the Federal Reserve
After several years of steady growth, stock market prices began to rise rapidly
in 1995, more than tripling over the next five years. In 2000, stock prices began a
prolonged decline. Shortly thereafter, in March 2001, the longest expansion in history
ended, and the economy entered a recession. By September 2002, the Standard and
Poor’s 500 Index had fallen by nearly half from its peak. In hindsight, it is clear that
some of the appreciation in stock prices in the 1990s was caused by a “bubble,” a rise
in price that cannot be attributed to underlying economic fundamentals, but is instead
caused by “irrational exuberance.”
Around the same time that the stock market boom was coming to an end, the
housing boom began. House prices have doubled since 1997 and increased more
than 50% from 2003 to 2006. Since 2006, prices have stagnated, while sales and
housing construction have declined precipitously. In August 2007, problems with
subprime mortgages led to widespread financial turmoil. This has led some analysts
to conclude that a similar asset bubble has infected the housing market.
These experiences have led some critics to question the Federal Reserve’s
(Fed’s) policy of non-intervention toward bubbles. If bubbles reflect harmful
economic imbalances, they argue, then the proper policy response is to raise interest
rates to neutralize them. This proposal faces two main drawbacks. First, bubbles
cannot be accurately identified and their magnitude cannot be estimated until after
the fact. Theory suggests that the Fed would be able to accurately identify bubbles
only if it knew more than the thousands of professionals participating in those
markets who believed high prices to be justified. Second, aggressively raising interest
rates to counteract a bubble risks instigating the very recession that critics ostensibly
wish to avoid. The relative shallowness and brevity of the 2001 recession is seen as
evidence in favor of a hands-off policy response to a bubble.
Fed Chairman Ben Bernanke has argued that the Fed should respond to a bubble
only insofar as it causes inflation or growth to rise above sustainable levels, but need
not be concerned about eliminating a bubble for its own sake. Bubbles lead to higher
investment in the affected industry and consumption spending (by making
households feel wealthier). According to Bernanke’s philosophy, the Fed could raise
interest rates in response to a bubble if this spending increase were inflationary.
Assuming Bernanke’s philosophy were correct, the issue of whether the Fed has
responded to bubbles aggressively enough in practice to prevent them from igniting
inflationary pressures remains. The Fed waited until 1999 to raise interest rates
during the stock market boom, and cut rates in 2007 in response to financial turmoil.
Both of these episodes have been marked by rising inflation, and if increases in house
prices were recorded in the owner-occupied shelter portion of the consumer price
index, recorded inflation would be even higher today. Critics also argue that the
Fed’s passive approach to a growing bubble is inconsistent with its aggressive rate
reductions following a bubble’s deflation, and this inconsistency sends a message to
investors to take on excessive risk. This report will be updated as events warrant.

In troduction ......................................................1
What is a Bubble?.................................................4
What Effect Does a Bubble Have on the Economy?.......................7
Effects on Investment, Consumption, and GDP......................7
Effects on Inflation............................................11
What Should the Federal Reserve Do About Bubbles?....................14
Policy Response As a Bubble Inflates.............................14
Policy Response After a Bubble Has Burst.........................20
Conclusion ......................................................21
List of Figures
Figure 1. S&P 500, 1990-2006.......................................2
Figure 2. House Price Index vs. Rental Index, 1990:1-2007:2...............3
Figure 3. Growth Rate of Investment by Type, 1995-2006.................8
Figure 4. Shelter Inflation Using Mortgage Costs Compared to the Rental
Equivalence Measure, 1999-2006................................13

Asset Bubbles: Economic Effects and
Policy Options for the Federal Reserve
After several years of steady growth, equity (stock) market prices began to rise
rapidly in 1995. From the beginning of 1995 to its peak in August 2000, the value
of the Standard and Poor’s index of the 500 largest firms had more than tripled in
nominal terms (see Figure 1). The sharpest increases in equity prices were
concentrated in high-tech stocks. Prices on the NASDAQ, an exchange known for
listing smaller high-tech firms, were six times higher at the peak than in 1995.
During this period, extravagant claims were made about a “new economy” that defied
the old economic laws, and about the easy, sure-fire way to make money through
equity investments.1 At the same time, many economists cautioned that the stock
market was in the grips of a speculative bubble, an increase in prices unrelated to
fundamental determinants of value, that would eventually burst and impoverish many
of the same investors that it had hitherto made rich. Alan Greenspan, then-Chairman
of the Federal Reserve, cautioned against “irrational exuberance” in the equity market2
in 1996, and Yale economist Robert Shiller released a widely read book of the same
title in 2000.3

1 See, for example, Stephen B. Shepard, “The New Economy: What it Really Means,”
Business Week, November 17, 1997, p. 38.
2 Typically, Greenspan’s actual words were more ambiguous than the interpretation they
were universally given: “Clearly, sustained low inflation implies less uncertainty about the
future, and lower risk premiums imply higher prices of stocks and other earning assets. We
can see that in the inverse relationship exhibited by price/earnings ratios and the rate of
inflation in the past. But how do we know when irrational exuberance has unduly escalated
asset values, which then become subject to unexpected and prolonged contractions as they
have in Japan over the past decade?” Remarks by Chairman Alan Greenspan, “The
Challenge of Central Banking in a Democratic Society,” at The American Enterprise
Institute, Washington, D.C., December 5, 1996.
3 Robert Shiller, Irrational Exuberance (Princeton: Princeton University Press, 2000).

Figure 1. S&P 500, 1990-2006

1990 1993 1996 1999 20 02 2005
Source: Yahoo! []
In 2000, the trend abruptly reversed, and stock prices began a prolonged decline.
Shortly thereafter, in March 2001, the longest expansion in history ended, and the
economy entered a recession. By September 2002, prices on the S&P 500 had fallen
by nearly half from their previous peak, and prices on the NASDAQ were one-
quarter of their former peak. In hindsight, it seems clear that some portion (though
not all) of the 1990s stock market rise and subsequent decline was indeed caused by
a bubble, or an increase in price that is caused by psychological factors, speculation,
or error rather than economic fundamentals. The pattern was reminiscent of the stock
market crash that preceded the Great Depression in 1929 or the decade of economic
stagnation in Japan in the 1990s,4 although this time the effects were far more benign.
Before the stock market crashed, seemingly similar events were starting to occur
in housing markets, as shown in Figure 2. After several years of solid growth, house
price appreciation suddenly began accelerating in mid-1997, with further escalation
since 2003. According to the house price index (HPI), prices have doubled since
1997 and increased more than 50% since 2003. To date, the HPI has not shown any
national decline in housing prices, although the market is slowing down.5 In contrast,
more recent data from another source suggest that house prices may have already
begun to decline.6 Housing sales and residential investment (house building) have
already declined at double digit rates. Mortgage deliquency rates have risen, and as
4 For more information, see CRS Report RL30176, Japan’s “Economic Miracle”: What
Happened?, by William Cooper.
5 Office of Federal Housing Enterprise Oversight, “House Price Index,” press release,
September 5, 2007.
6 U.S. Census Bureau, “New Residential Sales in August 2007,” news release, September

27, 2007.

a result, there was widespread financial turmoil in August 2007 that originated with
subprime mortgage-backed securities.7
Figure 2. House Price Index vs. Rental Index, 1990:1-2007:2

199 0 1992 19 94 1996 19 98 2000 20 02 2 004 200 6
Source: Office of Federal Housing Enterprise Oversight, Bureau of Labor Statistics
Note: House Price Index is a repeat sales index of owner-occupied homes; rent index is rent
of primary residence from the consumer price index.
Some economists have argued that the housing market is also suffering from a
bubble, whereas some commentators argue that owner-occupied housing will always
be a bargain investment.8 While the efficacy of using monetary policy in response
to the 1990s stock market bubble may seem obvious now, it is useful to remember
that opinions on the existence of an equity bubble were equally divided at the time.
The rise and fall of the stock market led to widespread debate among
economists and policymakers that the end of the housing boom has only intensified.
Should the Federal Reserve have responded to the stock market bubble (and now the
housing boom) when it first emerged by raising interest rates to promptly extinguish
it before it took off? If it had done so, could a recession have been avoided? Is the
targeting of asset bubbles consistent with the Fed’s dual mandate of maximum
employment and low inflation? How can bubbles emerge when standard economic
theory strongly predicts they cannot? And given theoretical predictions, how would
7 See CRS Report RL34182, Financial Crisis? The Liquidity Crunch of August 2007, Darryl
E. Getter, Mark Jickling, Marc Labonte, Edward Vincent Murphy.
8 For a complete analysis of the issue, see CRS Report RL31918, U.S. Housing Prices: Is
There a Bubble?, by Marc Labonte.

the Fed be able to accurately identify a bubble? This debate is important to Congress
in order to effectively exercise its oversight duties for the Federal Reserve.9
What is a Bubble?
Economic theory suggests that in a competitive market, price is determined by
supply and demand, and equals the marginal cost of producing the good. A market
is said to be competitive when there are many buyers and sellers who are perfectly
informed and rational, prices can be easily altered, and there are no barriers to entry.
A bubble is said to occur when price does not equal marginal cost. Standard
economic theory (called “efficient markets” theory) strongly concludes that bubbles
cannot occur in competitive markets because any time price exceeds marginal cost,
producers will increase their supply, thereby pushing price back down to marginal
cost. At first glance, few markets seem to better fit the “perfect competition” criteria
than the markets for equities and homes — there are millions of buyers and sellers,
an enormous number of transactions take place, information abounds, professional
analysts closely evaluate market trends, prices adjust rapidly, and so on. Few goods
markets meet these criteria.
Equity prices are based on the present discounted value of future dividends and
price appreciation. Obviously, it is extremely difficult to accurately forecast these
values into the distant future, and this would seem to suggest that bubbles could
form. Still, standard theory rules out bubbles developing based solely on uncertainty
for two reasons. First, theory predicts that systematic errors will not be made by
market participants overall. In other words, optimistic and pessimistic prediction
errors should on average nearly cancel out. Most participants should not
systematically overestimate future prices, as a bubble implies. Second, standard
theory does not necessarily require all market participants to be equally smart or
sensible. But it predicts that less skilled participants will eventually be driven out of
the market because they regularly lose money in transactions with more skilled
participants. In other words, analysts who recognize the existence of a bubble should
be able to profit from it by selling stocks short, and in the process of short selling, the10
bubble should be deflated. This possibility seems to rule out a large and protracted
bubble similar to the one that developed in the 1990s.11

9 This report analyzes only the Fed’s monetary policy responsibilities. In the case of a
housing bubble, the Fed also has relevant banking regulatory oversight duties. An analysis
of regulatory options is beyond the scope of this report.
10 An investor would sell the market short by borrowing the asset from one party and selling
it to a third party. When the loan came due, the price of the asset would have fallen back
to its fundamental value and the investor could pay back the loan at a profit. There are two
shortcomings to this argument in reality. First, investors face credit constraints, and if
bubbles remained for long periods of time, investors might not be able to borrow for long
enough to profit. Second, under the “uptick rule” short selling of a security is prohibited
when the price of that security is falling on the NYSE and AMEX (SEC Rule 10a-1.) This
rule does not preclude short selling as the bubble is growing, however.
11 For a recent defense of efficient markets theory, see Burton Malkiel, “The Efficient

So why would these markets suffer from bubbles? Economists who accept that
bubbles do occur in reality argue that people are not always as rational as theory
predicts. Psychological behavior such as herd mentality,12 overconfidence, “animal
spirits” (as coined by John Maynard Keynes), and biased self-attribution (taking
credit for one’s success and blaming others for one’s failure) may trump logic at
times.13 People seem to have a tendency to project past results forward (into the
future) with little regard for whether fundamentals would justify such an assumption.
A one-time improvement in fundamentals should be matched with a one-time
increase in prices; in which case, there is no reason to think that future appreciation
rates will match recent rates. And yet, the longer that high returns persist, the more
certain people become that those returns will persist in the future, and the larger the
bubble becomes.
In his classic study, Kindleberger argued that a bubble often emerges after a
legitimate shift in fundamentals that warrants some increase in asset prices.14 In the
case of equity prices in the 1990s, fundamental changes such as the acceleration in
productivity growth, reduction in inflation, increased appetite for risk, strength and
duration of that economic expansion, and so on merited some legitimate increase in
stock prices. In hindsight, it is clear that these fundamental changes did not justify
the full increase in stock prices that actually occurred. Yet, at the time, financial
professionals justified the price rises by using optimistic assumptions about
fundamentals within standard models.15 (Most famously, in 1999 two economists
released a book entitled Dow 36,000, which argued that stock prices had not yet risen
nearly high enough based on fundamentals.16) These explanations may have been
highly unlikely, but they were not impossible; therefore, finding the dividing line at
the time between the legitimate price increase and the bubble was impossible.

11 (...continued)
Market Hypothesis and Its Critics,” Journal of Economic Perspectives, vol. 17, no. 1, Winter


12 See Ivo Welch, “Herding Among Security Analysts,” Journal of Financial Economics,
vol. 58, 2000, p. 369.
13 Psychologically based causes of the bubble are analyzed in detail in Robert Shiller,
Irrational Exuberance (Princeton: Princeton University Press, 2000).
14 Charles Kindleberger, Manias, Panics, and Crashes, Fourth Edition (New York: John
Wiley and Sons, 2000), Ch. 2. In the book, Kindleberger chronicles historical bubbles.
15 Economist Timothy Cogley demonstrates that small modifications to economic
fundamentals lead to large changes in fundamental prices. For example, if economic growth
increased from 2% to 3% annually, equity prices would rise 28.4%. If the spread between
stocks and bonds fell from 8 percentage points (the average since 1926) to 5 percentage
points (the average since 1966), equity prices would rise 110%. Timothy Cogley, “Should
the Fed Take Deliberate Steps to Deflate Asset Price Bubbles?”, Federal Reserve Bank of
San Francisco, Economic Review, no. 1, 1999, p. 42.
16 James Glassman and Kevin Hassett, Dow 36,000, Crown Business Publishing, 1999.
Likewise, Nobel prize winner Edward Prescott and his co-author argued that stock market
was not overvalued in 2000. Ellen McGrattan and Edward Prescott, “Is the Stock Market
Overvalued?,” National Bureau of Economic Research, working paper 8077, January 2001.

Similar fundamental explanations can be found for why house prices have risen
in recent years — lower mortgage rates reduced borrowing costs dramatically,
innovations in mortgage markets reduced liquidity constraints (e.g., down payments
have fallen and access to credit has risen), following the stock market crash,
individuals perceived homes as relatively more desirable investments, and lower
inflation reduced the relative up-front costs of a mortgage. Still, there is a limit to
how far price increases can be justified by these explanations. For example, the only
change to have occurred from 2003 to 2006 is a greater prevalence of non-traditional
mortgages (which some see as a symptom of a bubble), yet prices increased more
than 50% in that time. And builders should respond to higher demand by increasing
the housing stock, which would push prices back down (although this factor is
limited in areas where land is limited). Just as today’s stock prices should reflect
future dividends and appreciation, today’s home prices should reflect the future costs
and benefits of ownership. Costs of ownership include maintenance and borrowing
costs; benefits include forgone rent payments and tax deductions. Any increase in
prices should reflect a change in these costs and benefits or else it is caused by a
bubble. With extreme enough assumptions about, say, future rental savings or
mortgage rates, nearly any increase in housing prices can be justified. So it is
impossible to currently identify a housing bubble with any certainty.
The housing market differs from an ideal competitive market in one important
way: supply responds to price changes with a lag, and in some areas is constrained
by a lack of open land. This means that a rise and (even subsequent decline) in price
in the housing market is more ambiguous than in the stock market — it could be
fundamentals at work (greater demand causes prices to rise, which increases supply
with a lag). The housing market may also be further from the competitive ideal than
the stock market because there is no short selling, there are high transaction prices,
the profit motive is not the only motivation for buying, and most buyers and sellers
have little expertise. Expecting the average buyer to be able to make complex
calculations about future parameters may be unrealistic. On the other hand, it is
easier to project a home’s future price than a company’s future earnings, because the
projection is based on a tangible asset. While people will not readily switch from
ownership to rental housing, ultimately a comparison of ownership costs to rents will
influence people’s decisions at the margins, and should therefore not move too far
Discussions of a housing bubble should be cognizant of the fact that there is no
national housing market. Price patterns vary widely across different regions — while
prices in some regions have risen much more rapidly than the national average, other
regions have seen little real appreciation in the recent boom. Thus, if there is a
housing bubble, it is a series of localized bubbles, not a nationwide bubble.
The failure of economic theory to accurately predict bubbles does not mean that
bubbles do not exist or theory is useless. What it does suggest is that it would be
very hard for policymakers to accurately predict a bubble until after the fact.17 For

17 For efforts to identify bubbles empirically, see Refet S. Gurkaynak, “Econometric Tests
of Asset Price Bubbles: Taking Stock,” Federal Reserve Board of Governors, Finance and

example, economist Randall Kroszner, now a Fed governor, points out that the bull
equity markets of the 1950s and 1980s were about as strong as the 1920s and 1990s
markets. Based on price appreciation alone, there is no way to tell until after the fact
that the former two would keep rising in price while the latter two would turn out to
be bubbles.18
What Effect Does a Bubble Have on the Economy?
Effects on Investment, Consumption, and GDP
Asset price bubbles do not have any direct effect on gross domestic product
(GDP) because GDP measures the current production of goods and services, while
a bubble represents a change in the price of an existing asset. Bubbles indirectly
affect the economy because economic agents alter their behavior in response to the
change in the price signal. For example, when a corporation’s stock price rises, it
may respond by increasing its physical capital investment spending higher than it
otherwise would have.19 Likewise, when housing prices rise, developers may
respond by increasing the housing stock more than the market can profitably support
in the long run.
As shown in Figure 3, the responsiveness of investment spending to price
changes can clearly be seen in the data. When equity prices were rising, (non-
residential) physical capital investment spending increased from $763 billion in 1995
to $1,232 billion in 2000. Following the stock market crash in 2000, investment
spending declined to $1,072 billion in 2002. Both the rise in equity prices and
investment spending were heavily concentrated in the high-tech sector of the
economy during the boom, and equity prices and investment spending fell
disproportionately in that sector after the crash. Investment spending on information
processing (IP) equipment and software grew more than 15% each year from 1995
to 2000. Similarly, residential investment (housing construction) boomed in recent
years in tandem with house prices, rising from $449 billion in 2001 to $597 billion
in 2005. As the housing boom ended, it then fell to $570 billion in 2006. (All data
are adjusted for inflation and expressed in 2000 dollars.)

17 (...continued)
Economics Discussion Series 2005-04, January 2005.
18 Randall Kroszner, “Asset Price Bubbles, Information, and Public Policy,” in William
Hunter, et al., eds., Asset Price Bubbles, (Cambridge: MIT Press, 2003), p. 4.
19 See also Simon Gilchrist, et al., “Do Stock Price Bubbles Influence Corporate
Investment?”, Federal Reserve Bank of New York, staff report no. 177, February 2004.

Figure 3. Growth Rate of Investment by Type, 1995-2006

20 n on -re s i de nti al
0 chinvestment
-5%IP equipment
-10and software
Source: Bureau of Economic Analysis
Note: IP equipment and software is a sub-component of non-residential investment.
This suggests that bubbles may cause a misallocation of resources that leads to
inefficiencies in the economy. For example, the “dot-com bubble” of the 1990s
probably led to too much investment spending by high-tech companies relative to the
rest of the economy. Some of these investments probably never generated output that
justified their cost. Yet in the aggregate, this misallocation did not seem particularly
costly to the economy since the dot-com sector was too small to singlehandedly have
a large effect on the overall economy. However, Japan arguably provides an example
where the misallocation problem was more costly for the overall economy, and
contributed to persistent economic stagnation after the bubble burst.
More debatably, economists have also proposed that aggregate spending will be
affected by a “wealth effect” when asset prices rise and fall.20 According to this
logic, when asset prices rise, asset holders would use some of their new-found wealth
to boost their consumption spending. Evaluating the importance of the wealth effect
is difficult because asset prices and consumption are not exogenous — for example,
rapid GDP growth or lower interest rates would cause both to rise simultaneously.
Some of what is popularly identified as a wealth effect (such as mortgage
refinancing) should more properly be considered the standard results of monetary
easing. Furthermore, attributing a wealth effect to housing is problematic because
an increase in the price of existing housing makes the seller richer, while
simultaneously making the buyer equally poorer (income that the buyer could have
used on other goods must instead be devoted to financing the purchase of the
20 See, for example, James Poterba, “Stock Market Wealth and Consumption,” Journal of
Economic Perspectives, vol. 14, n. 2, Spring 2000, p. 99; Karl Case, John Quigley, and
Robert Shiller, “Comparing Wealth Effects: The Stock Market Versus the Housing Market,”
National Bureau of Economic Research, working paper 8606, November 2001.

house).21 In any case, the size of the wealth effect relative to overall economic
activity is likely to be modest because the life cycle theory predicts that spending
from an increase in wealth would be spread equally across one’s lifetime. For
example, a Federal Reserve economist calculated that assuming a marginal
propensity to consume from wealth of 0.04, an estimate within the standard range,
the stock market decline from 2000 to 2002 would reduce GDP growth by 0.36
percentage points. As the author points out, this estimate is small enough to be
indistinguishable from normal fluctuations in economic activity.22 In fact,
consumption grew far more rapidly than overall GDP during the recent stock market
decl i n e. 23
From a policymaker’s perspective, the fortunes of a particular industry may
matter less than the overall economy’s ability to generate full employment. The
importance of bubbles, therefore, will depend largely on how damaging they are to
the economy’s overall health. If the economy can shrug off a bursting bubble and
continue to smoothly expand, then preventing bubbles would probably not be a
policy priority. Alternatively, if bubbles lead to recessions or financial crises when
they burst, then policymakers have a strong incentive to stop bubbles before they
A bubble could lead to difficulties in the financial system if it caused a large
firm or a number of firms holding the assets which are declining in value to
experience insolvency or illiquidity.24 Financial firms are interdependent, and if the
troubled firm is unable to honor its obligations, trouble could spill over to other firms
with which it had dealings. If the problem became serious and widespread enough,
it could prevent the smooth functioning of financial intermediation, causing non-
financial firms difficulty in financing their own operations, thereby feeding through
to the general economy. Crisis in the banking sector is what made the Great
Depression so long-lasting and deep. Since then, when financial unrest has
threatened, the Fed has stepped in to prevent any financial problems from becoming
more generalized.25
Falling house prices and rising mortgage rates have already resulted in financial
problems for issuers of and investors in mortgage-backed securities, and in August

2007, these problems spread throughout the financial system and caused a liquidity

21 There is not a similar issue when stocks rise in value because the buyer is purchasing the
right to a larger stream of future profits. When an existing house rises in value, it does not
generate more income — the buyer is paying more for the same future stream of shelter
22 Paul Gomme, “Why Policymakers Might Care About Stock Market Bubbles,” Economic
Commentary, Federal Reserve Bank of Cleveland, May 15, 2005.
23 Bureau of Economic Analysis, National Income and Product Accounts.
24 For a model illustrating how the bursting of a real estate bubble could lead to a banking
crisis, see Richard Herring and Susan Wachter, “Bubbles in Real Estate Markets,” in
William Hunter, et al., eds., Asset Price Bubbles (Cambridge: MIT Press, 2003), ch. 14.
25 See CRS Report RS21986, Federal Reserve: Lender of Last Resort, by Marc Labonte.

crunch.26 Although the Fed was able to restore overall liquidity relatively quickly,
it is too early to tell at this date if the liquidity crunch will have any broader and
lasting damage for the financial system or the economy.27
The most famous, and arguably misunderstood, bubble in U.S. history occurred
in 1929, when the stock market crash coincided with the onset of the Great
Depression. While the stock market crash may have helped instigate that economic
contraction, the consensus among economists is that the bubble had little to do with
the depth or duration of the Depression. Instead, most economists blame the
contraction in the money supply, which in turn led to widespread bank failures, for
the Depression’s severity.28 Likewise, Japan’s economic stagnation in the 1990s may
have started with the bursting of equity and property bubbles,29 but most economists
attribute its unusual persistence to tight monetary policy, problems in the banking
sector, and structural rigidities in the overall economy. These experiences suggest
that policymakers’ reaction to a bubble is as important as the bubble itself in
influencing economic activity.30
By contrast, two more recent experiences suggest that a bubble’s effect on the
overall economy need not be so severe. In October 1987, the stock market suffered
its largest single day percentage decline, yet the economy expansion continued for
two more years. And although the stock market decline eliminated $5.7 trillion in
wealth from 2000 to 2002, the decline in output that followed was the mildest since
World War II (although the decline in employment was deeper and longer lasting
than the decline in output). Since the decline in stock prices beginning in 2000 was
unusually large, it may provide a worst-case scenario for a bubble’s effect on the
economy, provided the Federal Reserve responded as it did then, by easing monetary
policy rapidly. And it cannot be ruled out that other factors were equally or more to
blame for causing the recession than the bursting of the bubble, including the
preceding tightening of monetary policy, the disruption caused by the attacks of

26 See CRS Report RL34182, Financial Crisis? The Liquidity Crunch of August 2007,
Darryl E. Getter, Mark Jickling, Marc Labonte, Edward Vincent Murphy.
27 As another example, Massachusetts saw a large increase in mortgage default rates and
bank failures following its real estate bust in the early 1990s. See David Wheelcock, “What
Happens to Banks When Housing Prices Fall?”, Federal Reserve Bank of St. Louis, Review,
September 2006, p. 413.
28 Popular accounts of the 1929 crash often blame the Fed for allowing the bubble to inflate.
Cogley argues that, on the contrary, the Fed aggressively tightened monetary policy in
response to the bubble, and this contributed to the severity of the ensuing depression. For
example, it raised the discount rate from 3% to 6% between 1928 and 1929 even though the
price level was falling. Timothy Cogley, “Should the Fed Take Deliberate Steps to Deflate
Asset Price Bubbles?”, Federal Reserve Bank of San Francisco, Economic Review, no. 1,

1999, p. 42.

29 More than 15 years after its peak, the Nikkei Index is still more than 50% below its peak
30 For a review of all of the stock market crashes of the 20th century and their economic
effects, see Frederic Mishkin and Eugene White, “U.S. Stock Market Crashes and Their
Aftermath: Implications for Monetary Policy,” in William Hunter, et al., eds., Asset Price
Bubbles, (Cambridge: MIT Press, 2003), ch. 6.

September 11 (although those occurred near the end of the recession), the increase
in oil prices, and the unusually lengthy duration of the expansion, which presumably
could not last forever.
The nation has never experienced a housing bubble before in the post World
War II period — nominal prices have never fallen significantly. (Prices fell in the
early 1980s when adjusted for inflation, but not nominally. The decline was probably
caused by the recession and sharp increase in mortgage rates, and not as a result of
a bubble.) Therefore, it is difficult to judge how severe an effect on the economy a
bursting housing bubble could have. (Since house prices are still rising according to
the HPI, it is too soon to draw any conclusions about the current situation.) There are
historical examples of sharp declines in local housing prices in California, New
England, and Texas. All three of these episodes took place during serious economic
contractions.31 It is difficult to say, however, whether these price declines caused
economic difficulties, or were merely the result of economic difficulties. For
example, the Texas episode is attributed to the sharp decline in energy prices in the
mid-1980s. There are historical examples of when housing prices have stalled, and
in these cases residential investment spending has fallen sharply — by a cumulative
41% from 1980 to 1982 and 24% from 1988 to 1991. Presumably, the bursting of
a housing bubble could result in even larger declines. Residential investment
accounts for too small a share of GDP to cause a recession single-handedly, however.
For example, it accounted for an average of 0.4 percentage points of GDP growth
from 2003 to 2005, and reduced GDP growth by 0.3 percentage points in 2006. For
a recession to occur, a decline in residential investment would need to be
accompanied by broader financial distress — it remains to be seen if the turmoil of
August 2007 will be long lasting — or a significant wealth effect on consumption.
Effects on Inflation
Just as bubbles have no direct effect on output, bubbles are also not measured
in inflation because inflation is defined as the change in price of goods and services,
not existing assets. In the late 1990s, some analysts argued that measures like the
consumer price index (CPI) or the GDP deflator under-measured inflation because
equity prices were not included in their definition of inflation. This argument is
incorrect — these measures, by definition, are meant to capture changes in the prices
of goods and services, not assets. A change in equity prices is a change in “paper
wealth” with no direct effect on the price of goods and services; it may change a
household’s purchasing power, but this will register in measured inflation as soon as
the household increases its consumption in response. If individuals change their
consumption slowly in response to rising asset prices, then changes in asset prices
may be a good predictor of future inflation in the goods market,32 but in practice it

31 For more information, see CRS Report RL31918, U.S. Housing Prices: Is There a
Bubble?, by Marc Labonte.
32 This argument is made in Charles Goodhart, “Time, Inflation, and Asset Prices,”
unpublished working paper, September 1999 and Armen Alchian and Benjamin Klein, “On
a Correct Measure of Inflation,” Journal of Money, Credit, and Banking, February1973. For
a rebuttal, see Andrew Filardo, “Monetary Policy and Asset Prices,” Federal Reserve Bank

would be impossible to distinguish between a rise in asset prices due to real factors
(which would not affect inflation) versus expected inflation. And it is unclear why
expected future inflation would be manifested in asset prices, but not more traditional
measures such as surveys or inflation-indexed Treasury bonds. Thus, the consensus
among economists is that asset price increases may be one (of many) useful predictor
of future inflation, but should not be included in measurements of actual inflation.33
Although the argument to include asset prices in inflation is theoretically weak
for equity prices, it is on much stronger ground when applied to housing prices.
Conceptually, a house is not seen as a consumption good, but rather as a physical
asset that generates a stream of consumption services called “shelter.” In fact, shelter
is one of the biggest expenditures in the basket of goods and services measured by
the CPI (owner-occupied shelter accounts for 23% of the CPI basket34). Thus, it
would stand to reason that an increase in house prices would therefore be registered
in the CPI as a rise in the cost of shelter. But, as measured in the CPI, the rise in
house prices has had no effect on the cost of shelter.35 That is because the CPI
records the “cost” of owner-occupied shelter as the rent that the owner could get for
his house if he rented it out. Since this cannot be measured directly, it is imputed in
the CPI from similar rental properties. (For that reason, it is referred to as the “rental
equivalence method” of measuring shelter inflation.) In the absence of a bubble, the
cost of owner-occupied shelter and rental properties should be equal, since a house’s
fundamental price is equal to the present discounted value of the future opportunity
cost of renting. But if a bubble were present, then, by definition, the cost of owner-
occupied shelter has diverged from the cost of rental properties. This suggests that
when a bubble is present, a more direct measure of housing costs would yield a more
accurate measure of inflation.36
There is an alternative approach to measuring the cost of owner-occupied shelter
called the “user-cost method,” which measures the direct costs of providing the
shelter instead of the cost of foregone rent associated with the house. (From 1950 to

1983, shelter was measured in the CPI using a similar method.) If a bubble were

32 (...continued)
of Kansas City, Economic Review, Third Quarter 2000, p. 11.
33 See James Stock and Mark Watson, “Forecasting Output and Prices: the Role of Asset
Prices,” National Bureau of Economic Research, working paper 8180, March 2001.
34 Robert Poole et al., “Treatment of Owner-Occupied Housing in the CPI,” presentation to
the Federal Economic Statistics Advisory Committee, December 2005.
35 Unlike the CPI, the GDP deflator measures the change in price of current production,
which includes the construction of new homes but excludes existing homes. The inflation
rate for residential investment in the GDP deflator has been fairly rapid in recent years,
averaging 4.9% from 2001-2005, but it makes up a relatively small fraction of the overall
36 In defense of the current measurement, David Johnson argues that the increase in house
prices should be thought to affect the cost of the investment component of housing, not the
consumption component, and it is therefore correct to omit it from the CPI. See David
Johnson, “The Rationale for How BLS Measures Shelter Services in the CPI,” Business
Economics, January 2006, p. 62.

present, inflation would rise under the user-cost method and not the rental equivalent
method. For most homeowners, the primary cost of housing is mortgage costs. Of
course, lower mortgage rates in recent years have reduced borrowing costs at the
same time that higher house prices have raised borrowing costs. Any alternative
measure of owner-occupied shelter inflation would need to take both into account.
While not a true user-cost measure of inflation, Figure 4 compares the BLS
rental equivalence measurement of inflation to a measure of inflation based on the
mortgage cost (which is the single largest determinant of user costs) for a constant
quality house.37 When measured by mortgage costs, shelter inflation rose faster than
5% per year in 1999, 2000, and 2004 to 2006 — all years when house prices and
mortgage rates both rose.38 Perhaps surprisingly, shelter costs experienced deflation
from 2001 to 2003, despite rapidly rising housing prices, because of falling mortgage
rates. By contrast, the measure of shelter costs used in the CPI has shown little
fluctuation in recent years, never exceeding 4.1%. In fact, even as inflation surged
by the mortgage cost measure, shelter inflation declined to 2.4% in 2004 and 2005.
Figure 4. Shelter Inflation Using Mortgage Costs Compared to the
Rental Equivalence Measure, 1999-2006


5%n r
19 99 2 001 2 00 3 200 5
mortgage costrental equivalence
Source: BLS, CRS calculations based on data from Census Bureau.
Note: “Mortgage cost” is the rate of increase in borrowing costs based on prevailing
mortgage rates and the price of Census’ constant quality house. Mortgage rates are the
composite mortgage rate used by the National Assoication of Realtors to calculate the
housing affordability index.
37 Increases in house prices due to quality improvements should not be included in a measure
of inflation. Therefore, the calculations in Figure 4 are based on Census’ constant quality
house price index.
38 Of course, many homeowners have fixed-interest mortgages that would not change when
mortgage rates change. This would reduce the overall inflationary effects of a change in
mortgage rates using a user cost method.

As can be seen in the figure, the major drawback to a user-cost method is the
extreme volatility in price changes that it generates. This volatility occurs because
small changes in interest rates lead to large changes in mortgage payments. The
Bureau of Labor Statistics prefers using the rental equivalence measure in the CPI
because it is less volatile, and therefore sends smoother signals of inflationary
pressures. Nevertheless, it should be recognized that the smoothness of inflation
using the rental equivalence method comes at a price — Figure 4 suggests that the
economy may currently be experiencing inflationary pressures that are not being
recorded in the CPI.
What Should the Federal Reserve
Do About Bubbles?
Policy Response As a Bubble Inflates
Congress has mandated that the Federal Reserve maintain full employment and
low and stable price inflation.39 The Fed has discretion to develop whatever strategy
it sees fit to accomplish these goals. One important reason for not giving the Fed a
longer or more detailed list of goals to accomplish is that the Fed has only one tool
available to fulfill its mandate: its ability to alter short-term interest rates. It can
therefore pursue only one goal at a time, so giving it more goals would dilute its
ability to accomplish any particular goal. For that reason, a shift toward using
monetary policy to eliminate asset bubbles would be justified only if it was a goal
whose importance was on par with the existing mandated goals, or if it could help
better accomplish the existing mandate.
As stock prices rose more and more rapidly in the late 1990s, amidst the general
climate of exuberance, there was a growing chorus of critics calling for the Fed to
step in and raise interest rates high enough to prick the bubble before it got any
bigger.40 (Higher interest rates increase a firm’s borrowing costs and reduce its
profitability, which should, all else equal, reduce the firm’s market value.) They
argued that the larger the bubble was allowed to get, the more damaging it would be
to the economy when it eventually burst. The Fed’s response was far more cautious:
wait and see what effect the potential bubble has on the economy, and then respond

39 For more information, see CRS Report RL30354, Monetary Policy: Current Policy and
Conditions, by Marc Labonte and Gail Makinen.
40 See, for example, “Bubble and Squeak,” The Economist, vol. 347, issue 8067, May 9,
1998, p. 17; Dean Baker, “Double Bubble: The Implications of the Overvaluation of the
Stock Market and Dollar,” Center for Economic Policy and Research, June 2000.

to any changes in economic activity.41 Then-Chairman Alan Greenspan testified in
1999 that
monetary policy is best primarily focused on stability of the general level of
prices of goods and services as the most credible means to achieve sustainable
economic growth. Should volatile asset prices cause problems, policy is probably
best positioned to address the consequences when the economy is working from42
a base of stable product prices.
Critics argued that this strategy was dangerous. In their eyes, the bubble was a
clear indication of where the economy was headed — toward a cycle of overheating,
followed by contraction — and the Fed should have responded pre-emptively to
prevent it. They argued that Fed policy amounted to waiting to act until it was
already too late. After the stock market began declining in 2000, they questioned the
discrepancy between the Fed’s eagerness to cut interest rates sharply at that point
compared to its passivity when stocks were rising, fearing this asymmetry in response
encourages investors’ recklessness.43 Yet, perhaps the weakest point in the critics’
argument is that any attempt to prick the bubble risks instigating the very recession
that the critics argue the bubble will cause. In Greenspan’s words was far from obvious that bubbles, even if identified early, could be
preempted short of the central bank inducing a substantial contraction in44
economic activity — the very outcome we would be seeking to avoid.
The current Fed Chairman Ben Bernanke’s philosophy on bubbles has closely
followed Greenspan’s. In a 2002 speech, he argued
If we could accurately and painlessly rid asset markets of bubbles, of course we
would want to do so. But as a practical matter, this is easier said than done,

41 It is demonstrated statistically that the Fed did not respond to asset price movements
(outside of any effect they had on inflation or output) in Ben Bernanke and Mark Gertler,
“Monetary Policy and Asset Price Volatility,” Federal Reserve Bank of Kansas City,
Economic Review, 1999, Fourth Quarter, p. 17. See also Jagjit Chadha et al., “Monetary
Policy Rules, Asset Prices, and Exchange Rates,” International Monetary Fund, Staff
Papers, vol. 51, no. 3, 2004. That paper finds that including asset prices as an explanatory
variable improves predictions of monetary policy modestly, although this may be only
because asset prices are a good proxy for inflation or output forecasts. See also Roberto
Rigobon and Brian Sack, “Measuring the Reaction of Monetary Policy to the Stock Market,”
Quarterly Journal of Economics, vol. 118, p. 639. Based on empirical data, the authors
estimate that a 5% increase in stock prices led to a 0.14 percentage point increase in the
federal funds rate. They argue that this is consistent with a policy of the Fed responding to
stock price increases only to the extent that they influence aggregate spending.
42 Testimony of Chairman Greenspan before the Joint Economic Committee, US Congress,
June 17, 1999.
43 One justification for the discrepancy might be that the inflating of the bubble was gradual
but the deflating was sudden. Sudden changes in equity prices are more likely to affect
overall economic activity than gradual changes.
44 Alan Greenspan, “Economic Volatility,” speech at a symposium sponsored by the Federal
Reserve Bank of Kansas City, Jackson Hole, Wyoming, August 30, 2002.

particularly if we intend to use monetary policy as the instrument, for two main
reasons. First, the Fed cannot reliably identify bubbles in asset prices. Second,
even if it could identify bubbles, monetary policy is far too blunt a tool for45
effective use against them.
These views are fleshed out in a 1999 paper by Bernanke, then an academic
economist, and economist Mark Gertler that demonstrated an asset bubble’s effect
on a theoretical model of the economy that validated the Fed’s strategy at the time.46
The authors show that in the presence of a bubble, inflation and employment stay
closer to their desired levels in the model when the Fed targeted inflation (which,
they argue, was close to actual Fed policy) than when it targeted the bubble. They
do not argue that monetary policy should remain unchanged in the presence of an
asset bubble. Rather, they argue, interest rates should respond to the bubble only
insofar as the bubble affects inflationary pressures.47 Once its inflationary effects48
were negated, the Fed should allow the bubble to remain. This argument was
important because it offered a rebuttal to critics of the Fed that claimed the Fed was
carelessly ignoring the equity bubble’s effects on the economy.
Whether this strategy worked as well in reality as it did in theory is an open
question. But it helps clarify two distinct criticisms of Fed policy at the time, and
perhaps today. One line of criticism would acknowledge that the Fed’s use of policy
to negate the bubble’s effect on inflation and employment was the correct strategy,
but underestimated the bubble’s effect, and therefore did not respond vigorously
enough in the 1990s — or today.49 (For a discussion, see the text box.) In that light,
if a bubble were a good predictor of future inflation, targeting it could be justified
since monetary policy affects inflation with a lag. The other line of criticism would
argue that bubbles are undesirable, and the economy cannot be thought to be
operating on a sustainable path until they are eliminated. In this view, eliminating
bubbles would be a legitimate policy goal in and of itself, since a bubble is
incompatible with economic stability.

45 Ben Bernanke, “Asset Price ‘Bubbles’ and Monetary Policy,” Speech before the National
Association of Business Economics, New York, NY, October 15, 2002.
46 Ben Bernanke and Mark Gertler, “Monetary Policy and Asset Price Volatility,” Federal
Reserve Bank of Kansas City, Economic Review, 1999, Fourth Quarter, p. 17.
47 This view, which is echoed in his 2002 speech, is at odds with Bernanke’s statement that
the Fed cannot identify bubbles with much certainty, since the Fed cannot respond to a
bubble’s inflationary effects unless it can identify the bubble.
48 Perhaps the most unrealistic aspect of their model is the assumption that private
individuals foresee that the Fed will stamp out the inflationary effects of the bubble, which
allows the Fed to do so with very little actual increase in interest rates. This assumption
leads to a much more benign outcome than if the Fed did raise rates sharply to cancel out
the bubble’s inflationary effects. It seems a leap of faith to assume that investors are
forward looking enough to anticipate the Fed’s reaction so precisely, but are not forward
looking enough to prevent the bubble from emerging in the first place.
49 Economist John Taylor goes further and uses econometric simulations to argue that if the
Fed had responded more vigorously to inflationary pressures from 2002 to 2006, the housing
bubble could have been avoided. John Taylor, “Housing and Monetary Policy,” working
paper, presented at Federal Reserve Bank of Kansas City symposium, September 2007.

How Has the Fed Responded to Potential Bubbles to Date?
As discussed above, the current Fed chairman and his predecessor take the
position that the Fed will alter policy in response to a bubble only to the extent that
the bubble affects inflationary pressures or employment. This raises the question
of how aggressively the Fed believes it should act to achieve that policy, and
whether it has been aggressive enough. Critics believe the Fed has responded too
weakly when bubbles have arisen.
In the late 1990s, the Fed kept the federal funds rate flat until 1998, when it
was reduced by 0.75 percentage points in response to concerns about financial
stability resulting from the Russian debt default and insolvency of the hedge fund
Long Term Capital Management. The Fed did not raise rates until 1999, at which
point, rates were increased by 1.75 percentage points over the next year. At best,
it could be argued that the Fed belatedly responded to the equity bubble beginning
in 1999. However, inflation was rising in 1999 and exceeded 3% in 2000 (as
measured by the consumer price index CPI), and the unemployment rate had fallen
below 4% for the first time since the 1960s, so it is possible that these rate
increases were carried out without any consideration of equity prices.
Fed governors and regional presidents expressed concern about a financial
bubble many times in the transcripts from the Federal Open Market Committee
(FOMC) meetings between 1996 and 1999. Fed officials were more candid in the
transcripts about their certainty a bubble existed than they were in public
statements (in fact, their internal forecast in November 1997 projected a 20%
decline in stock prices in 1998). And yet, monetary policy was not tightened until
1999. For example, as early as December 19, 1995, Chairman Greenspan stated
that “The real danger is that we are at the edge of a bond and stock bubble.... That
is the reason why, if we are perceived to be easing policy, it is conceivable that we
could foster further problems in that regard.” In spite of those fears, the Fed
decided to reduce interest rates by 0.25 percentage points at that meeting.
In the current decade, the federal funds rate steadily rose from 1% in 2004 to
5.25% in June 2006. Again, it is difficult to say to what extent these rate increases
were motivated by concern about a potential housing bubble. In a June 2005
congressional testimony, Chairman Greenspan said, “Although a ‘bubble’ in home
prices for the nation as a whole does not appear likely, there do appear to be, at a
minimum, signs of froth in some local markets where home prices seem to have
risen to unsustainable levels.” Most of the rate increases were merely removing
the stimulus previously put in place in response to the 2001 recession, moving
current policy back to a more neutral level. Adjusted for inflation, the federal
funds rate is still not particularly high at present based on standard measures of
monetary policy. And inflation has shown a clear rising pattern since 2003,
exceeding 3% since 2005 (as measured by the CPI), so tightening may be
motivated by traditional concerns, without reference to house prices. In September
2007, the Fed reduced rates in response to the liquidity crunch spurred by
subprime mortgage problems that began in the previous month. It remains to be
seen whether the rate cut helps or hinders housing market adjustment. Transcripts
of the FOMC meetings are released with a five year lag, so it will be some time
before it is known how concerned the Fed was privately about a housing bubble.

Fed economist Glenn Rudebusch poses the latter view in terms of a tradeoff
between better long-term outcomes (since the bubble would not be allowed to grow
larger until it burst on its own) at the cost of worse short-term economic outcomes
(since growth would temporarily be reduced by the effort to eliminate the bubble).
He believes a legitimate case can be made for the tradeoff, but only if it meets three
strong tests, which he argues are unlikely to be met in practice.50
First, Rudebusch says, policymakers must be able to accurately identify bubbles
before they burst. While it may seem obvious after the fact that an equity bubble
existed in the late 1990s, as Greenspan put it at the time,
bubbles generally are perceptible only after the fact. To spot a bubble in advance
requires a judgment that hundreds of thousands of informed investors have it all51
wrong. Betting against markets is usually precarious at best.
If the Fed had acted on the assumption that there was a bubble, it would have been
going against the expert opinion of many, if not most, financial market professionals
at the time. This would have been problematic for the Fed both analytically and
politically (since shareholders are unlikely to be happy that the Fed is pursuing a
policy of reducing their wealth). The uncertainty in identifying a bubble makes a
policy response potentially costly. If the Fed guesses correctly that there is a bubble
and responds, then economic outcomes could improve. But if it guesses incorrectly,
output and/or inflation would be more volatile than they otherwise would have been.
Second, the Fed must be unable to readily mitigate the damage done after the
bubble bursts, according to Rudebusch. In other words, if lower interest rates can
quickly bring the economy back to full employment after a bubble has burst (as was
the case in 2001), then there is nothing to be gained by using monetary policy to
eliminate the bubble before the fact. For example, Fed governor Mishkin uses the
Fed’s macroeconomic simulation model to show that a 20% decline in house prices
can be offset by lowering interest rates by 0.75 percentage points so that GDP growth
falls by only 0.5 percentage points at the peak year.52 On the other hand, if the
bursting of the bubble were to lead to a financial crisis or a credit crunch that caused

50 Glenn Rudebusch, “Monetary Policy and Asset Price Bubbles,” Economic Letter 2005-18,
Federal Reserve Bank of San Francisco, August 2005. These views are echoed in a 2007
speech by Fed governor Frederic Mishkin. See Frederic Mishkin, “The Role of House
Prices in Formulating Monetary Policy,” remarks at the Forecasters Club of New York,
January 17, 2007.
51 Testimony of Chairman Greenspan before the Joint Economic Committee, US Congress,
June 17, 1999. Fed economist Timothy Cogley takes Greenspan’s point one step further and
argues that the Fed knows less about financial markets than market professionals, and will
thus be unable to ever determine whether perceived equity mispricing is caused by a bubble
or by the Fed’s errors in estimating fundamentals. Timothy Cogley, “Should the Fed Take
Deliberate Steps to Deflate Asset Price Bubbles?”, Federal Reserve Bank of San Francisco,
Economic Review, no. 1, 1999, p. 42.
52 Frederic Mishkin, “Housing and the Monetary Transmission Mechanism,” working paper
presented at Federal Reserve Bank of Kansas City symposium, August 2007, p. 35. This
assumes that the Fed reacts as it has historically; Mishkin argues that the negative effect on
growth would be even smaller if the Fed reacted more aggressively.

significant disruption the economy, pre-emptive action could be advantageous.53 It
could also be advantageous if the bubble causes resources to be misallocated across
sectors of the economy, since monetary policy is too blunt to be aimed at specific
sectors. The importance of avoiding a recession depends largely on how important
one believes the misallocation problem to be. There are those who follow the maxim
of Andrew Mellon, Treasury Secretary at the onset of the Depression, “Liquidate
labor, liquidate stocks, liquidate the farmers, liquidate real estate. It will purge the
rottenness out of the system.”54 In their eyes, misallocated resources are the problem,
and recessions can be a useful cure; in this case, bubbles should be stamped out
regardless of the costs. In contrast, mainstream macroeconomic policymaking sees
recessions as the chief problem, and is relatively indifferent about the misallocation
of resources.
Finally, Rudebusch says, a pre-emptive monetary tightening must be an effective
means of deflating the bubble to be warranted. Greenspan doubted this would be the
nothing short of a sharp increase in short-term (interest) rates that engenders a
significant economic retrenchment is sufficient to check a nascent bubble. The
notion that a well-timed incremental tightening could have been calibrated to55
prevent the late 1990s bubble is almost surely an illusion.
In other words, the “irrational exuberance” driving the bubble was unlikely to be
quelled by a small rise in interest rates. Only a large increase in rates, he claimed,
would affect a bubble, and such an increase would be highly likely to cause a
recession. Asset prices might also be unresponsive to short-term interest rate changes
if they do not feed through to long-term interest rate changes (which the Fed does not
control). For example, the Fed increased short-term rates from 1.1% to 3.2%
between 2003 and 2005, but 10-year Treasury rates only rose from 4% to 4.3% and
mortgage rates from 5.7% to 5.9% over that time. If a bubble were unresponsive to
interest rate hikes or the reduction in GDP growth from such hikes was greater than
would occur when the bubble burst, then there would be no advantage to a pre-
emptive policy. Another drawback to using monetary policy to negate a potential
housing bubble is the localized nature of the bubble. Monetary policy cannot be

53 Using a cross-country sample, economists Borio and Lowe show that credit expansion is
a better predictor of subsequent financial crisis than equity price increases, but the
combination of both is the best predictor. They point out that crises in East Asia in the

1990s and Latin America in the 1970s were not preceded by large increases in equity prices.

Claude Borio and Phillip Lowe, “Imbalances of ‘Bubbles’? Implications for Monetary and
Financial Stability,” in William Hunter, et al., eds., Asset Price Bubbles (Cambridge: MIT
Press, 2003), ch. 17.
54 Quoted in Timothy Cogley, “Should the Fed Take Deliberate Steps to Deflate Asset Price
Bubbles?”, Federal Reserve Bank of San Francisco, Economic Review, no. 1, 1999, p. 42.
55 Alan Greenspan, “Economic Volatility,” remarks at a symposium sponsored by the
Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August 30, 2002. Chairman
Bernanke agreed with this argument and offered empirical evidence that small increases in
interest rates do not reduce stock prices enough to eliminate a bubble. Ben Bernanke,
“Monetary Policy and the Stock Market: Some Empirical Results,” Speech at Widener
University, Pennsylvania, October 2, 2003.

targeted to specific regions, and regions without a bubble would share in the
contractionary effects of higher interest rates.
Policy Response After a Bubble Has Burst
As discussed above, the Fed’s belief that monetary policy can be effectively
used to counteract the damage done by a deflating bubble is central to its position that
it need not interfere with a growing bubble. Whenever financial markets have
dropped sharply during Chairman Greenspan’s or Bernanke’s tenure (including
episodes in 1987, 1998, 2001, 2007), the Fed has responded by reducing interest
rates. In the eyes of many economists, the 2001 and 2007 declines were the result of
bursting asset bubbles. In Chairman Bernanke’s words,
It is not the responsibility of the Federal Reserve — nor would it be appropriate
— to protect lenders and investors from the consequences of their financial
decisions. But developments in financial markets can have broad economic
effects felt by many outside the markets, and the Federal Reserve must take those56
effects into account when determining policy.
In other words, a sharp decline in financial markets may result in a decline in
economic growth, and in order to maintain stable economic growth, the Fed must
offset the financial decline by cutting interest rates or adding liquidity to financial
Nevertheless, critics argue that there is an asymmetry between the Fed’s laissez-
faire approach to inflating asset bubbles and its interventionary approach to deflating
bubbles. Further, they argue that the asymmetry has an important effect on investor
behavior because it increases moral hazard, the economic term for the idea that
people take greater risks when they are insured against adverse outcomes. In this
case, in the words of the head of Britain’s central bank,
The provision of such liquidity support undermines the efficient pricing of risk
by providing ex-post insurance for risky behavior. That encourages excessive57
risk-taking and sows the seeds of a future crisis.
These critics argue that more efficient investment decisions would be made in the
long run if the Fed allowed financial downturns to run their course and imprudent
investors took losses.58 The Fed’s alacrity when prices fall could even make a future
bubble larger than it otherwise would be since the Fed’s actions reduce the payoff to

56 Chairman Ben Bernanke, “Housing, Housing Finance, and Monetary Policy,” Speech at
the Federal Reserve Bank of Kansas City’s Economic Symposium, August 31, 2007.
57 Carter Dougherty, “British Central Bank Critical of Cash Infusions,” New York Times,
September 13, 2007. Soon after, the British central bank appeared to reverse its stance by
providing financial markets with significant liquidity.
58 The moral hazard argument should not be overstated. Investors will only be “bailed out”
in instances when their losses correspond with responses by the Fed, and plenty of investors
still experienced losses during financial turmoil despite the Fed’s actions.

investors betting against a bubble, thereby interfering with the market’s tendency for
The drawback to the moral hazard critique is that allowing financial turmoil to
run its course could run counter to the Fed’s long-run goal of maintaining economic
stability. If turmoil were to lead to recession, not only would overly risky investors
take losses, but so would efficient firms that saw demand for their products drop
solely because of the cyclical downturn. Some would argue that liquidity has
characteristics of a positive externality, whose benefits to society exceed the benefits
to private firms who provide it. If so, enough liquidity can be provided only through
government intervention, in this case by the Fed.
Although the positive externality argument is generally consistent with
mainstream economic thought, it and the moral hazard critique are not mutually
exclusive. Traditionally, government programs that create moral hazard are
complemented by government regulations to reduce risky behavior. For example,
deposit insurance creates the incentive for banks to take on excessive risk, so bank
regulations restrict the amount of risk that banks are allowed to take. If moral hazard
really is being created by the Fed, there may not currently be corresponding
regulations to offset the extra risk it generates.
Bubbles are difficult to identify with confidence until after the fact. This limits
the ability of policymakers to respond to bubbles effectively. Nevertheless, their
effect on the economy has been demonstrated to be significant enough that there is
risk in ignoring them. Bubbles lead to volatility in investment spending,
consumption, and, in the worst case scenario, financial instability. Because the rise
in house prices is not captured in the CPI and other inflation measures, true
inflationary pressures in the economy may have been greater than measured in recent
years, possibly suggesting that the economy is overheating.
Critics have argued that the Fed should act more aggressively to counteract
bubbles when they form. The Fed has responded that such a policy would detract
from its mandated goals to keep inflation and economic growth stable. The greatest
drawback of the critics’ argument is that aggressively raising interest rates to
counteract a bubble risks instigating the very recession that they ostensibly wish to
The Fed claims that it will respond to bubbles insofar as they affect economic
growth or inflation, but a case can be made that the Fed has underestimated the effect
of bubbles on the overall economy, and inflation and growth have been less stable
than desired as a result. Looking at the historical record, there is strong evidence that
the Fed has followed its stated policy that it would not purposely eliminate bubbles.
At most, it has tightened policy slightly more than would be justified by inflation and
output alone when possible bubbles have formed. But it certainly cannot be ruled out
that the interest rate path the Fed has pursued would have been exactly the same in
the absence of any potential bubble. Since the Fed is not explicit about how different

factors are weighted in its decision-making process, there is no way to settle this
argument definitively.
The Fed did not raise interest rates in the face of unusually rapid increases in
stock prices until 1999. The sharp fall in stock prices in 2000 would seem to
vindicate the Fed’s critics at first glance, but the Fed could also argue the experience
proved its policy to be correct. The 2001 recession was one of the mildest and
briefest declines in output since World War II (although it did not look nearly as mild
from the perspective of the job market). Efforts to deflate the bubble earlier may
very well have resulted in a recession of equal or greater magnitude. Besides a slow
recovery in capital investment spending, the economy showed few lasting scars from
the stock market crash. By 2003, capital investment spending had fully rebounded
as well. And although a bubble seems to have formed at some point, it does not seem
to have been as large in hindsight as critics had predicted. For example, at its trough,
the S&P 500 was still 10% higher than it was when Greenspan made his “irrational
exuberance” speech. Thus, although policy intervention may have been justified at
some point, it was probably not nearly as early as critics had demanded. Had the
critics’ policy been pursued, some of the rapid output gains of the last few years of
the 1990s expansion could have been lost. The burden of proof remains with critics
that a policy of deflating bubbles would meet Rudebusch’s three tests: accurate
identification, improved macroeconomic stability, and effective deflation.
Part of the Fed’s rationale for not interfering when bubbles are forming is its
belief that expansionary monetary policy can be used to avoid any serious
ramifications from a bursting bubble. Although this has been true in the past — it
is still too soon to tell how well this strategy worked in August 2007 — critics argue
that the asymmetry in its response creates a moral hazard problem. Since investors
believe that the Fed will “bail out” markets when a bubble crash, they have the
incentive to take larger risks, perhaps even resulting in larger bubbles than would
otherwise have formed