	Introduction

After several years of steady growth, equity (stock) market prices began to rise rapidly in 1995. In 2000, the trend abruptly reversed, and stock prices began a prolonged decline. Shortly thereafter, in March 2001, the longest expansion in history ended, and the economy entered a recession. By September 2002, prices on the S&P 500 had fallen by nearly half from their previous peak, and prices on the NASDAQ were one-quarter of their former peak. In hindsight, it seems clear that some portion (though not all) of the 1990s stock market rise and subsequent decline was indeed caused by a bubble, or an increase in price that is caused by psychological factors, speculation, or error rather than economic fundamentals. According to the house price index (HPI), prices have doubled since 1997 and increased more than 50% since 2003. Mortgage deliquency rates have risen, and as a result, there was widespread financial turmoil in August 2007 that originated with subprime mortgage-backed securities. Some economists have argued that the housing market is also suffering from a bubble, whereas some commentators argue that owner-occupied housing will always be a bargain investment. Should the Federal Reserve have responded to the stock market bubble (and now the housing boom) when it first emerged by raising interest rates to promptly extinguish it before it took off? And given theoretical predictions, how would the Fed be able to accurately identify a bubble? This means that a rise and (even subsequent decline) in price in the housing market is more ambiguous than in the stock market—it could be fundamentals at work (greater demand causes prices to rise, which increases supply with a lag). And it cannot be ruled out that other factors were equally or more to blame for causing the recession than the bursting of the bubble, including the preceding tightening of monetary policy, the disruption caused by the attacks of September 11 (although those occurred near the end of the recession), the increase in oil prices, and the unusually lengthy duration of the expansion, which presumably could not last forever. Of course, lower mortgage rates in recent years have reduced borrowing costs at the same time that higher house prices have raised borrowing costs. Any alternative measure of owner-occupied shelter inflation would need to take both into account. The current Fed Chairman Ben Bernanke's philosophy on bubbles has closely followed Greenspan's. Rather, they argue, interest rates should respond to the bubble only insofar as the bubble affects inflationary pressures . Policy Response After a Bubble Has Burst

As discussed above, the Fed's belief that monetary policy can be effectively used to counteract the damage done by a deflating bubble is central to its position that it need not interfere with a growing bubble. Conclusion

Bubbles are difficult to identify with confidence until after the fact. Bubbles lead to volatility in investment spending, consumption, and, in the worst case scenario, financial instability. The greatest drawback of the critics' argument is that aggressively raising interest rates to counteract a bubble risks instigating the very recession that they ostensibly wish to avoid. The Fed claims that it will respond to bubbles insofar as they affect economic growth or inflation, but a case can be made that the Fed has underestimated the effect of bubbles on the overall economy, and inflation and growth have been less stable than desired as a result. The Fed did not raise interest rates in the face of unusually rapid increases in stock prices until 1999. The sharp fall in stock prices in 2000 would seem to vindicate the Fed's critics at first glance, but the Fed could also argue the experience proved its policy to be correct.
After several years of steady growth, stock market prices began to rise rapidly in 1995, more than tripling over the next five years. In 2000, stock prices began a prolonged decline. Shortly thereafter, in March 2001, the longest expansion in history ended, and the economy entered a recession. By September 2002, the Standard and Poor's 500 Index had fallen by nearly half from its peak. In hindsight, it is clear that some of the appreciation in stock prices in the 1990s was caused by a "bubble," a rise in price that cannot be attributed to underlying economic fundamentals, but is instead caused by "irrational exuberance."
Around the same time that the stock market boom was coming to an end, the housing boom began. House prices have doubled since 1997 and increased more than 50% from 2003 to 2006. Since 2006, prices have stagnated, while sales and housing construction have declined precipitously. In August 2007, problems with subprime mortgages led to widespread financial turmoil. This has led some analysts to conclude that a similar asset bubble has infected the housing market.
These experiences have led some critics to question the Federal Reserve's (Fed's) policy of non-intervention toward bubbles. If bubbles reflect harmful economic imbalances, they argue, then the proper policy response is to raise interest rates to neutralize them. This proposal faces two main drawbacks. First, bubbles cannot be accurately identified and their magnitude cannot be estimated until after the fact. Theory suggests that the Fed would be able to accurately identify bubbles only if it knew more than the thousands of professionals participating in those markets who believed high prices to be justified. Second, aggressively raising interest rates to counteract a bubble risks instigating the very recession that critics ostensibly wish to avoid. The relative shallowness and brevity of the 2001 recession is seen as evidence in favor of a hands-off policy response to a bubble.
Fed Chairman Ben Bernanke has argued that the Fed should respond to a bubble only insofar as it causes inflation or growth to rise above sustainable levels, but need not be concerned about eliminating a bubble for its own sake. Bubbles lead to higher investment in the affected industry and consumption spending (by making households feel wealthier). According to Bernanke's philosophy, the Fed could raise interest rates in response to a bubble if this spending increase were inflationary.
Assuming Bernanke's philosophy were correct, the issue of whether the Fed has responded to bubbles aggressively enough in practice to prevent them from igniting inflationary pressures remains. The Fed waited until 1999 to raise interest rates during the stock market boom, and cut rates in 2007 in response to financial turmoil. Both of these episodes have been marked by rising inflation, and if increases in house prices were recorded in the owner-occupied shelter portion of the consumer price index, recorded inflation would be even higher today. Critics also argue that the Fed's passive approach to a growing bubble is inconsistent with its aggressive rate reductions following a bubble's deflation, and this inconsistency sends a message to investors to take on excessive risk. This report will be updated as events warrant.