The Fed And Bubbles

Justin Lahart with an excellent post on the WSJ about the Fed trying to avoid bubbles in the future:

"Once authorities identify a bubble, the next step is figuring out how to deal with it. Fed officials appear uncomfortable with the idea of raising interest rates to prick a bubble, because rates affect a wide swath of economic activity, and a bubble may be confined to just one area.

"Monetary policy, for which we in the Federal Reserve are responsible, is a blunt instrument with economy-wide effects," said Federal Reserve Bank of Minneapolis President Gary Stern. "We should not pretend that actions taken to rein in those asset-price increases, which seemingly outstrip economic fundamentals, won't in the short run curtail to some extent economic growth and employment."

Fed officials are leaning toward regulating financial firms with more of a focus on how they are contributing to risk throughout the financial system. This approach could also have drawbacks, said Princeton economist Hyun Song Shin.

"These Wall Street people are very intelligent, and their incentives are so vast that they're going to find a way to go around the rules you set down," he said. "Leaning against the wind by raising interest rates in the face of what seems like a credit boom is one way of at least damping down on potential excesses."

This is the issue. If the Fed causes a slowdown in the economy in order to avoid a bubble, will that be accepted, or will people decry their action as limiting growth without enough cause. On the other hand, through lobbying and other means, they might not be able to deal with the problem companies effectively.