This uncertainty surrounding the current behavior of asset values complicates the task of assessing the future trajectory of asset prices, and the impact of alternative monetary policy paths on asset values. And by widening the already substantial degree of uncertainty that surrounds estimates of the equilibrium real rate of interest, these developments complicate the task of assessing the appropriateness of a given stance of monetary policy against the objectives of the Federal Reserve.

Monetary policy does not today and is unlikely in the future to offer us an effective tool for directly reducing the incidence of large or sustained deviations of asset values from what might turn out to be their fundamental values, what some call bubbles.

Successfully integrating asset prices into monetary policy formulation is also hard to do because of the difficulty of assessing how potential alternative paths for monetary policy will feed through to overall financial conditions and thereby for output and inflation—in other words it is difficult to forecast how changes in current or expected policy will affect asset values.

In circumstances where the central bank observes a large realized movement in asset prices and is confident in its knowledge of the impact of those moves on the path of aggregate demand, monetary policy may need to follow a different path than might have seemed appropriate in the absence of those developments.

This leaves us with no simple or clear doctrine for the role of asset prices in monetary policy regimes. Asset prices probably matter more than they once did, but what that means for monetary policy necessarily depends on the circumstances.

The recent Interagency Credit Risk Management Guidance for Home Equity Lending was not a regulatory effort to combat a housing price bubble, nor was it an example of regulatory suasion aimed at asset prices.  Rather, it was a response to indications that some banks were not appropriately managing risks in the home equity area.  The regulatory system is not designed to influence or control asset bubbles, but rather to ensure that bubbles, should they develop, do not lead to unsafe lending practices.  Although the guidance was not aimed at affecting asset prices directly, it may nevertheless affect market conditions through changes in the availability of credit for some riskier households.

The risk of rapid adjustments and unusual configurations of asset price movements is higher than normal.

Rising asset prices support household consumption, whereas falling asset prices damp consumption. In a scenario of collapse, the damage to balance sheets and private wealth could go as far as undermining the soundness of the financial system and threatening stability of the real economy.

Not all situations in which asset prices are rising rapidly under seemingly easy monetary conditions are worrisome. Some are quite benign and even signal a healthy economy.

Asset price movements that are discontinuous or extreme can affect the policy process...Because they are interest-sensitive, asset prices are primary components of the channels by which monetary policy is transmitted to the real economy. If these transmission channels are disrupted, the reliability and the effectiveness of policy are degraded. In the worst case, policy's room for maneuver may be narrowed or even severely compromised, and risks of a policy blunder are heightened.

Central bankers would benefit from a better understanding of asset price movements--particularly more extreme movements--so that we do not mistakenly facilitate in some way potentially harmful outcomes.

One might have thought that, with probably limited economic slack remaining, such a pronounced imbalance between national saving and domestic investment would have placed substantial upward pressure on interest rates. One also might have expected real interest rates to be high at a time when we are experiencing rapid productivity growth. But, as you know, nominal and real yields on both short-term and long-term Treasury securities are low by historical standards...suggesting that investors are sanguine about default risk and other types of uncertainty.

To the extent that current spending behavior is built on realistic expectations--in particular, for future short-term interest rates, the exchange rate, rates of return on capital investments in the United States relative to those abroad, and housing price appreciation--the transition should be relatively orderly: Asset prices should adjust gradually to changing developments, as should the spending patterns of households and firms. But if current expectations are badly distorted, then the way forward may not be so smooth...In such circumstances, asset prices can adjust sharply, and private spending may also respond quickly, making it difficult for monetary and fiscal policy actions to provide a timely enough counterweight to keep the economy continuously on track.

In the months following the sharp stock market decline, it was unclear how rapidly economic activity was decelerating. Once it became clear, the Federal Reserve responded aggressively...On the other side, in light of the uncertain and attenuated pattern of recovery and expansion, the Federal Reserve has taken a gradualist approach to removing the monetary accommodation and returning to a more neutral policy stance.

The imbalances in our fiscal and external positions could be diffused gradually and smoothly. But the transitions to a more sustainable equilibrium could also bring greater volatility in asset prices, less stability in macroeconomic outcomes, slower growth and more uncertainty.