Asset Bubbles: Economic Effects and Policy Options for the Federal Reserve (CRS Report for Congress)
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| Release Date |
Sept. 25, 2007 |
| Report Number |
RL33666 |
| Report Type |
Report |
| Authors |
Marc Labonte, Government and Finance Division |
| Source Agency |
Congressional Research Service |
Summary:
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.
