WSJ weighing in from Jackson Hole; last paragraph is the ominous part
from Wall Street Journal
The Outlook
JACKSON HOLE, Wyo.
The Federal Reserve's role in managing the economy, a former chairman once famously quipped, is to "take away the punch bowl just when the party gets going."
But what is the Fed supposed to do about the raucous stock market as it becomes an ever-bigger part of the economy?
The current Fed chairman, Alan Greenspan, his colleagues at the Fed, and other monetary-policy experts from around the world gathered at a mountain resort here last week to answer that touchy question. The emerging consensus: Leave the punch bowl alone. We may feel there's too much drinking, but who are we to judge? Besides, if we tried, the odds are we would either fail -- which would only embolden the partygoers further -- or we would have to destroy the dance hall to succeed.
Just because the Fed has decided against actively driving down the Dow Industrials doesn't mean Mr. Greenspan & Co. are ignoring the market's sharp rise. The Fed chairman declared in his keynote speech Friday that he's watching it more closely than ever. But officials have concluded that their appropriate role is more akin to a beat cop, not a chaperone. That is, to move to calm things down only when the neighborhood -- the broader economy -- gets disturbed. And most important, to be ready to clean up the streets quickly if the post-celebration damage spreads.
Ever since his "irrational exuberance" speech nearly three years ago, Mr. Greenspan has struggled to define how monetary policy should respond to the stock market. At the time, he appeared to be hinting that the Fed was contemplating actively pricking what it considered a bubble.
Hindsight has shown that that would have been folly. Whatever one thinks of the stock market's level today, few experts would now argue that a Dow Industrials level of 6500 in 1996 -- about 60% of the current level -- was overvalued. Fed officials still worry about the Dow average's altitude, and would be happier if it stopped rising for a time. But Mr. Greenspan's speech Friday was laced with humility about his ability to judge appropriate stock values. Market prices, after all, are set by "millions of investors, many of whom are highly knowledgeable about the prospects for the specific companies that make up our broad stock prices indexes," he noted.
Another reason the Fed has ruled out the popping option: Previous attempts to prick bubbles have ended badly, most notably the Fed's moves in 1929, and the Bank of Japan's campaign 60 years later. William Poole, president of the Fed's St. Louis bank, argues that there's an inherent contradiction in the logic of bubble-crushing: If you believe the market is acting irrationally on the way up, you have no way of predicting or controlling how it reacts on the way down. "We're treading on very, very dangerous ground, and I want to stay away from it," he says.
The best the Fed thinks it can do with a bubble is to keep its eye on its primary mission: containing inflation in prices for goods and services, not assets. That's the conclusion of a paper presented by two economists, Ben Bernanke of Princeton University and Mark Gertler of New York University and privately embraced by many attending Fed officials. If the stock market -- by fostering greater consumption, borrowing and lending -- leads to inflationary conditions in the broader economy, only then should the Fed respond by boosting rates. Otherwise, they wrote, "central banks should ignore movements in stock prices that do not appear to be generating inflationary or deflationary pressures."
Besides, a market crash need not be a calamity, Messrs. Bernanke and Gertler assert. As long as the Fed and other regulators make sure that other aspects of the economy, notably the banking system and corporate balance sheets, are healthy, the damage should be limited. The economists concluded that the U.S., where things look sound these days, could easily withstand a 25% market correction.
And the Fed could further move to limit the fallout by cutting rates if the crash seemed to create a real danger of slowing the economy. That's precisely what Mr. Greenspan did after the 1987 crash and again last year when U.S. financial markets were battered by the global financial crisis. That's what the Fed failed to do in 1930, as did the Bank of Japan in 1990.
It almost sounded as if world's wise men and women of monetary policy, meeting under antler chandeliers, had finally solved the nettlesome question of managing bubbles. But did they? What if U.S. balance sheets and banks only look healthy now because stocks are so high? What happens to these sound fundamentals if stocks plunge? What if Mr. Greenspan, by responding quickly to market swoons in 1987 and 1998, merely served to create an even bigger bubble -- by convincing investors that they will always be bailed out -- that will ultimately have an even more calamitous collapse?
Yutaka Yamaguchi, deputy director of the Bank of Japan, issued a sobering warning. He recounted the view from Tokyo in the mid-1980s. Growth was high and the stock market was soaring. But inflation was nonexistent. Japan's banks were the biggest in the world -- nobody foresaw weakness. So the central bank kept rates low, only later realizing it was inflating an economy-wrecking bubble. The parallels with the U.S. in the late 1990s were striking. How, some Americans in the audience wondered, can we be so sure that we have figured things out any better?
--Jacob M. Schlesinger
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