Is Fed Planning to Burst Monetary Bubble Before It Even <i> Is</i> a Bubble?

Central bankers believe it is their job to take away the punch bowl just when the party starts getting good. Fine. But just when the guests are arriving? That seemed to be the issue last month when two governors of the Federal Reserve Bank got into an exchange with Clinton Administration economists about the course of monetary policy. David Mullins, who is also the Fed’s vice chairman, and Lawrence Lindsey expressed concern that further interest rate cuts could create a bubble in financial markets, driving bond and stock prices to unjustifiable levels and setting the stage for a subsequent plunge.

Neither official suggested that bond and stock markets were currently too high. Nonetheless, many financial observers interpreted their remarks as a rationale not only against cutting interest rates further but also for possibly raising them from present levels, an interpretation that may have helped push both markets down.

Administration economists who spoke out in response to the Fed officials want no such upward bias in interest rate policy and reject the suggestion that stock and bond markets are approaching a speculative bubble. They presumably believe that further rate cuts by the Fed might be needed to keep the economic expansion healthy, and they certainly believe it would be wrong to start raising rates under current economic conditions.

What is an outsider to think? The concern over financial bubbles stems from experience in Japan, where the Nikkei stock average tripled between 1985 and 1989 and then crashed back to nearly 1985 levels by the end of last year.

But there are no parallels between what was going on there and what is now happening here. Japanese capital markets were riddled with irregularities that propped up prices, and the central bank was pushing down interest rates at a time when the economy was already late in a sustained boom.

The 1987 boom and crash in the U.S. stock market may also be on some people’s minds. Excesses of the takeover mania probably helped create euphoria in the stock market that year. But that stock run-up was hardly caused by low interest rates, although the crash when it finally came did follow an increase in rates here and in Europe. Again, there is little resemblance to conditions today.

As for today’s interest rate policy, the evidence on output, jobs and prices supports the Administration’s case. The expansion of output and employment was disappointing during the first half of the year, and now the deficit reduction package is tightening fiscal policy in the quarters ahead. This fiscal tightening in itself would slow the expansion still more unless it were offset by a lift to private demand from lower interest rates.

Because interest rates have already declined a lot, and the impact of that decline has not yet had its full effect, the expansion should continue and may even quicken in the months ahead despite the fiscal tightening. But this forecast is far from a sure thing, and the Administration properly wants an interest rate policy that is geared to assuring a healthy expansion. Furthermore, there is growing evidence and agreement among analysts that inflation poses no threat that should complicate policy choices at this time.

There is no reason to believe the Federal Reserve sees prospects for the economy differently than the Administration. Thus, when Govs. Mullins and Lindsey suggest that interest rate policy has to be conducted with an eye to avoiding a bubble in financial markets, they raise the possibility of moving interest rates in a way that might conflict with the pursuit of goals for output, inflation and jobs.

Whether a concern with purely financial bubbles should take precedence over the basic goals of stabilizing the overall economy is questionable. On the other hand, we could all agree that the Fed ought to avoid conducting policy in a way that needlessly destabilizes markets. But there is little reason to believe it risks doing so today by pursuing policies aimed at achieving a satisfactory recovery.

There is even less reason to believe the Fed could fine-tune its activities so as to avoid any future market decline. Markets fluctuate and overshoot and otherwise behave in ways that are not related to what policy-makers are doing and that are beyond their ability to predict or control.

They also respond predictably to major policy surprises. The policy surprise that would most upset markets today would be a premature increase in interest rates that disrupted the recovery long before we had achieved a healthy economy with good job markets for workers and restored profitability for firms.