Janet Yellen and popping speculative bubbles

During her Senate confirmation hearing, Janet Yellen, the soon-to-be Fed chief, was asked what action she would take if she saw a speculative bubble forming in financial markets.  Would she, like her predecessor Alan Greenspan, simply watch it grow, while presumably making ready to pick up the pieces after it popped?  …or would she act–presumably by raising interest rates–to nip it in the bud?

She said she would do the latter.  She added that at present she sees no bubbles on the financial horizon.

I’m not sure what this means.

It could just be that she’s saying she doesn’t believe in the theory of “rational expectations.” a simplifying assumption of academic economists that people are cold, calculating, wealth-maximizing automatons all of the time.  This is also a premise of most academic research in finance, despite centuries’ worth of overwhelming evidence that real people seldom act that way.

Or it could be that she’s making a stronger statement  …that if she’d been in charge, she would have raised interest rates to pop the Internet bubble of 1998-99  …and that she’d have done the same to pop the housing bubble of 2006-07, as well.

At the moment, I think her’s is a statement without much content.  Millions of Americans laid off in the Great Recession are still out of work.  The economy is scarcely overheating (although I think what we’re seeing now is as good as it will get).  And government policy in Washington is retarding economic expansion, not helping it along.  So it’s hard to see where the impetus for higher interest rates would come from–which is what the Fed is communicating by saying it will leave short-term interest rates at the current zero for at least the next two years.  Also, the Fed can’t get more accommodative than it is now.

Still, I think the Yellen statement is one to keep filed away for future reference.  It implies that when we eventually get out of the mess we’re in–and assuming Ms. Yellen is still around–that the financial markets will be on a shorter leash than during the professional lives of just about everybody working on Wall Street.  Chances are what she does will take Wall Street completely by surprise.


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