Critics of the Fed have long urged it to intervene in bubbles -- an argument that seems even stronger now. Had the Fed raised interest rates more aggressively in the early part of the decade, it is possible that banks would not have made so many questionable loans. We can't know for sure, of course. But we do know what did happen: From 2001 to 2003, the Fed lowered short-term interest rates 13 times, reaching a rock-bottom level of 1 percent. They stayed there another year, and thereafter rose at a painstaking pace. With credit so cheap, people and institutions borrowed as if there were no tomorrow. And when the bust came, it spawned the worst recession in 75 years.
What could the Fed have done about it? By law, the central bank is responsible for promoting maximum economic growth while maintaining stable prices. When bubbles burst, they wreak havoc on the economy, so reining them in should be considered part and parcel of keeping the economy growing.
This line of argument implies that the fed funds rate should have been higher in 2001-03. When one looks at the unemployment rate (red line), which was high, and inflation (blue line), which was low, the Fed's policy (green line) at the time seems pretty understandable.Recent experience provides good reason for reconsidering whether the Fed should pay more attention to possible asset price and credit bubbles. Using the traditional tool of adjusting the federal funds rate target to "pop" bubbles, however, burdens that single policy instrument with a third objective. Simultaneously keeping inflation and unemployment low has proven tricky enough. A more promising direction, I think, would be to consider whether regulatory tools, like bank leverage requirements, could be applied in a countercyclical fashion.