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ASSET BUBBLES….Should the Fed (and other central banks) try to prick asset bubbles before they get out of hand? In theory, sure, but as Mark Thoma points out, the problem is that we’re not very good at recognizing bubbles in the first place: “If we didn’t identify one of the largest bubbles in memory, and for the most part people didn’t, I’m not confident we will be able to come to any kind of consensus about ‘ordinary’ sized bubbles before it’s too late. And if that’s the case, waiting until we are certain we are observing a bubble will delay policy beyond the point where it can be helpful.”

So what to do? Mark suggests a simple solution: the Fed already reacts to ordinary inflation, which is calculated as a complex weighted average of the prices of various goods and services. When these prices rise faster than long-run fundamentals dictate — creating micro-bubbles, if you will — the Fed reacts by raising interest rates. But the Fed’s definition of inflation is incomplete:

There is one set of prices, however, that theory says ought to be part of the rate-setting decision, but they are missing. And interestingly, and perhaps only coincidentally, the one set of prices that are not monitored and responded to just happen to be the place where bubbles erupt — asset prices. But if we include these prices in the Fed’s policy rule so that whenever asset prices rise the Fed responds by increasing the target interest rate, and if we weight the asset prices properly so that some prices, e.g. housing prices, receive more weight (house prices are notoriously sticky, so theory says they ought to receive a lot of weight), then perhaps it’s much less likely that a little bubble turns into a big bubble. Asset price inflation will be stopped by increases in the federal funds rate (and if it isn’t stopped by interest rate hikes, then other measures can be implemented). With this approach, you don’t have to debate whether a particular price run is a bubble or not; if it is creating asset price inflation, then there will be an automatic response of the federal funds rate to temper the increase. To me, not having to know if it is a bubble or not is an attractive feature.

This might just be an example of the recency effect on my part, but it sure seems as if the last couple of decades have produced more than the usual number of asset bubbles. What’s more, they’ve become steadily more dangerous. On a proportionate scale, the U.S. subprime bubble wasn’t actually any bigger than either the Japanese or Swedish real estate bubbles of the late 80s/early 90s, but a combination of derivative speculation and the absolute size of America compared to either Sweden or Japan magnified it into a global disaster that previous bubblemeisters could hardly dream of.

So yes: it’s time to pull our heads out of the sand and start giving asset inflation some weight in Fed anti-inflation policy. It doesn’t have to dominate Fed policy, it merely needs to be a factor in it. Remember: the point isn’t to eliminate asset bubbles, only to try to tame them a bit. I imagine Ben Bernanke has other things on his mind at the moment, but this seems like something worth a serious rethink once the current crisis calms down a bit.