With the full extent of the housing bubble plainly in hindsight and the worst of it still unwinding in the economy, at least one Federal Reserve bank governor is speaking out against the use of monetary policy to cure the economy’s investment bubbles. Janet Yellen, president and CEO of the Federal Reserve Bank of San Francisco, in a panel today raised questions about the Keynesian “paradigm” of activist policy and potential inflation. The Keynesian school of economics supposes the necessary public sector responses to woes brought about by private sector activities should involve either monetary policy by the central bank or fiscal policy by the government. The theory, despite the criticism that it risks inflation at the expense of stimulating an economy out of depression, is widely embraced by economists while the practice is in evidence at the Fed. The Fed’s own role in the process, monetary policy or forcing rates down, is in fact the very thing Yellen questions in remarks today. While the theory should work in ideal circumstances, “the normal monetary transmission mechanism has been hobbled by dysfunctional money and credit markets,” Yellen warns. The extent of the housing bubble’s inflation, for example, has meant the market has further to fall in recovery, making efforts at the Fed to turn things around next to impossible. Yellen asks: “The role of the house price bubble in precipitating the current financial crisis places new urgency on a long-standing question: Should central banks attempt to deflate asset price bubbles before they grow large enough to cause big problems?” It would mark a substantial turnaround from reactionary policy to proactive, preventative policy, but Yellen says in some situations the aggressive action is necessary. “[W]e have vivid proof that markets sometimes don’t work, and that the unwinding of a bubble can dramatically harm economic performance and threaten financial stability.” In response to the growing housing bubble, for example, the Fed should have reversed monetary policy and raised rates to keep the bubble from inflating. According to Yellen, higher short-term rates would likely have pushed mortgage rates up and reigned in demand for housing, slowing the pace of house price increases. “[T]ighter monetary policy may be associated with reduced leverage and slower credit growth, especially in securitized markets,” Yellen says. “Thus, monetary policy that leans against bubble expansion may also enhance financial stability by slowing credit booms and lowering overall leverage.” It is not, however, a cure-all, as Yellen says dealing with bubbles can oftentimes reveal just how little is known about the particular price bubble. “I would not advocate making it a regular practice to lean against asset price bubbles,” Yellen adds. “But, in my view, recent painful experience strengthens the case for using such policies, especially when a credit boom is the driving factor.” Read Yellen’s remarks. Write to Diana Golobay.

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