A New Dawn at the Fed?

On Tuesday, Oct. 18, 2011, Chairman Ben Bernanke of the Federal Reserve said that the central bank might use monetary policy to deflate asset bubbles. In other words, if the Fed saw a potential bubble brewing, it might raise interest rates to cool things down before a whole lot of people got badly hurt.

This is a big step forward. Before you can solve a problem, you have to recognize that you have a problem. Previously, Chairman Bernanke seemed to be of the view that the Fed couldn't see a bubble, hear a bubble or speak of a bubble--at least not before the bubble painfully burst. That was problematic, since the Fed was a serial enabler of bubbles, with its periodic fire sales on credit and new paradigms. While it takes more than the Fed to tango in this respect--greedy, cynical, and manipulative banks and other market players are usually the leading dramatis personae--the central bank is the gatekeeper. It controls the cash spigot. Bubbles require cash, and a lot of cash, to thrive. The Fed decides how much cash will slosh around the financial system. The more it opens the floodgates, the bubblier things get. Conversely, shortening the shifts for the employees at the Fed's monetary printing press will drain off the punch bowl just as the party is warming up. The Fed can feed or starve the bubble, as it chooses.

In the past, the Fed hasn't wrassled with asset bubbles, which like gators are strong, mean and destructive. But if you don't get control over the gator, who knows where it will go and what it will do? While Bernanke didn't admit that the Fed has been an enabler of asset bubbles, he's taken a big step forward in acknowledging that the central bank can't sit idly by while the financial system dashes up to the edge of a cliff and positions its feet half over the edge.