Which Inflation?
The Federal Reserve (”Fed”) is tasked by Congressional charter to “to provide the nation with a safer, more flexible, and more stable monetary and financial system.” Most people consider the key role of the Fed to be keeping inflation low. Sure the Fed has other tasks, but that’s really the biggie.
Which Inflation?
But which inflation should the Fed keep low? The CPI is the most common representation of inflation, but there are certainly others. What about asset (e.g. stock price or home price) inflation? In other words, is the Fed responsible for keeping bubbles from forming in asset markets?
In 1997, none other than Alan Greenspan asked the question in his famous ‘irrational exuberance’ speech. It’s well documented that he and the other Fed governors knew a stock bubble was growing. But in the face of political pressure, the Fed, and more specifically Greenspan, did nothing to stop it.
Popping Bubbles
I’d argue than the Fed does, in fact, have a responsibility to curtail asset bubbles. It’s clear from both the 1990s stock bubble and the 2000s real estate bubble that manias certainly damage the overall economy. If the Fed’s job is to “provide the nation with a … safer monetary and financial system,” then one of its main elements must be the dampening of manias.
Unfortunately, the Fed has instead decided it will let bubbles run their course until they pop. Then, to ‘clean up’ the mess, flood the economy with liquidity, as they did after both recent bubbles. All that money has to find a home. It finds it - in the next asset bubble.
I believe what we’re seeing now in the private equity/LBO area is just such a result. It, like all bubbles, must pop. The purpose of a buyout is typically to whip the target company into shape and then sell it again. But what if, in a couple of years, there are no buyers?
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