BUSINESS

Federal Reserve Debates A Bubble-Popping Strategy

03/18/2010 05:12 am ET | Updated May 25, 2011

Amidst calls to bring greater transparency to the Federal Reserve, the central bank's leaders are torn over one key issue: can the Fed pop financial bubbles before they become dangerous?

As the much-criticized chairman Ben Bernanke faces a confirmation hearing in Congress on Thursday, the Wall Street Journal reports that the Federal Reserve is now looking to take a more proactive stance toward asset bubbles.

Of course, the Fed has long come under fire for missing -- or outright empowering -- the housing bubble and the credit crisis. In the WSJ's words, the Fed is currently "groping for alternatives" to its failed strategy.

According to minutes released from its closed door meeting last week, the Fed openly admitted that its officials are worried that record-low interest rates "could lead to excessive risk-taking in financial markets." For many, this admission was a long time coming.

In the near term, the Federal Reserve may already have more than a few candidates for the next financial bubble. Gold hit a record high on Tuesday; a hedge fund run by billionaire John Paulson owns more gold than many large countries. And many have pointed to the possibility of an a property bubble in Asia.

Here's the WSJ:

"..the question of whether and how to tackle bubbles before they burst is becoming a growing concern amid fears of new bubbles developing in commodities markets and in emerging economies. Gold prices are up more than 50% in a year's time. China's Shanghai Composite stock index is up more than 75% this year. Stocks in Brazil are up even more. Oil prices have rebounded. They remain far below last year's peaks but a return to those highs could fuel inflation in goods and services more directly than tech stocks or housing did."

But the explicit admission that the Fed can identify and should combat financial bubbles is, as Barry Ritholtz points out, a severe change of course for Bernanke. Ritholtz speculates that Bernanke is trying to distance himself from the low-interest, hands off legacy of Alan Greenspan:

Bernanke made his Fed bones, so to speak, back in 1999, when he presented a paper to Fed officials at their annual Jackson Hole meeting, arguing against the Fed popping bubbles. His argument? The Fed should focus on controlling inflation, not trying to manage the cycle of booms and busts.

That argument resonated with Easy Al.

Under Alan Greenspan, the Fed accomplished neither goal. The various Greenspan era bubbles such as tech-stocks, credit, oil and commodities boom, and of course, housing all ran their course unabated, with no interference from the Fed. Inflation -- much higher from 1999 to 2007 than CPI falsely reports -- also ran wild."

While Fed critics push to audit the central bank and kill the renomination of Bernanke, Henry Blodget argues that the next bubbles are already upon us. Blodget suggests the Fed should learn from the tenure of former chairman Paul Volcker, who raised interest rates in the early 1980s during a time of economic unease. As for our current regime Blodget says:

"Today, we are led by men like Ben Bernanke and Tim Geithner. Men who are so afraid of the consequences of making people pay for their profligacy and stupidity that they have restarted the debt bubble (free money and bailouts for Wall Street, FHA, cash for clunkers) and made Too Big To Fail a national policy."

Read the entire WSJ story here.

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