With all the recent economic turmoil and unprecedented actions taken by the Federal Reserve, it appears obvious that the longstanding Greenspan-era policy of not “pricking” asset bubbles, even if, by sensible definitions, one could be plainly observed to be taking shape, may need some rethinking.The way the conventional logic goes, since central bankers should not be assumed to know how to value assets better then the market, they should not engage in the business of choosing when asset pricing has gotten out of hand and setting monetary policy and other regulation that would seek to control the perceived mispricing.
As Ben Bernanke put it (borrowing a bit from Milton Friedman and Anna Jacobson Schwartz’s study on monetary history) in a 2002 speech entitled "Asset Price Bubbles and Monetary Policy" "I will argue today, I think for the Fed to be an "arbiter of security speculation or values" is neither desirable nor feasible."
Bernanke goes on “Thus, to declare that a bubble exists, the Fed must not only be able to accurately estimate the unobservable fundamentals underlying equity valuations, it must have confidence that it can do so better than the financial professionals whose collective information is reflected in asset-market prices. I do not think this expectation is realistic, even for the Federal Reserve. Moreover, I worry about the effects on the long-run stability and efficiency of our financial system if the Fed attempts to substitute its judgments for those of the market. “
Yesterday though, Federal Reserve Bank of Boston President Eric Rosengren offered some perspective that posed an interesting, albeit subtle, contradiction in a speech given during the Bank of Korea and Bank for International Settlements Seminar.
“I would argue that it is very difficult for a central bank to be an effective lender of last resort without significant knowledge of the current and prospective value of assets and liabilities within financial institutions. Like any counterparty, a central bank acting as a lender needs to be able to evaluate the solvency and liquidity of a borrowing institution.”
When outlining the qualification process used for banks that seek use of the Term Auction Facility (TAF), Rosengren adds “To qualify, a bank first needs to be in sound financial condition, as the Federal Reserve must have confidence that the bank will be solvent over the time the loan is extended. … Our Discount officers determine, as best they can, the market value of the collateral and apply an appropriate ‘haircut.’”
Aside from the dubious nature of a monetary policy that would seek to look the other way during the boom times while working overtime to create a floor under the market when the boom busts, Rosengren’s speech essentially draws a bright ironic spotlight on the fact that the Fed, having taken the substantial risk of junk mortgage securities on their own balance sheet, is now forced to determine asset prices in a VERY deliberate and real way.
The Federal Reserve is now precisely the “arbiter of security speculation” Bernanke had found so disagreeable in 2002 yet not by its cavalier choosing but by its desperate response to the truly dire circumstances brought on, at least in part, by its own unwillingness to address the obvious problems in the first place.
