Is the Fed Creating New Bubbles?

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Roubini's "mother of all carry trades" is not much in evidence, either. If lots of investors were borrowing dollars to invest in other assets, there would be an obvious spike in dollar loans. Instead, U.S. bank lending remains way off its peaks. Securitized lending in dollars by Wall Street firms is also down.

U.S. FIRST

Complaints from China and Hong Kong about the Fed's low rates are even easier to dismiss. If they allowed their currencies to appreciate vs. the dollar, as the U.S. has urged, the threat of asset bubbles would quickly recede. The Fed has to set rates for the good of the U.S. economy, which is clearly still in need of cheap money. On Nov. 18 the Commerce Dept. reported an 11% drop in October in the annual rate of starts on housing construction. The unemployment rate of 10.2%, nearing a postwar high, is weighing on all sectors of the economy.

Still, what if bubbles do start to form? The Fed says it will deal with them only to the degree that they affect its "dual mandate" from Congress—to keep overall prices stable and attain full employment. Jacking interest rates up and down in an effort to tame the stock market or other asset prices could cause bigger swings in prices and employment, Kohn said in a Nov. 16 speech at Northwestern University's Kellogg School of Management.

Instead of using interest rates to deflate bubbles, the Fed intends to employ what it calls "macroprudential regulation." That means regulating banks with an eye on markets, not just the bank's balance sheet. For example, a lending strategy that might look safe for any single bank is dangerous when lots of banks follow the strategy and all try to get out at once. One idea being pushed by the Fed and the Obama Administration is to require banks to tighten underwriting standards in good times, and build up thick capital buffers that could be used in bad times. "It's akin to caring for an entire ecosystem rather than individual trees," says Yellen.

The Fed's critics continue to worry that keeping interest rates near zero is the monetary equivalent of pouring gasoline on a fire. Paolo Pellegrini, who helped prick the housing bubble as a bearish hedge fund manager at Paulson & Co., says that trying to discipline markets through banking regulation while at the same time plying them with cheap money is "like having a very strongly worded law that says 'don't murder' and then going out and handing people lots of guns."

The debate over how to deal with asset bubbles isn't going away. It's "perhaps the most difficult problem in monetary policy of the decade," Bernanke acknowledged at the Economic Club luncheon. For now, count on the Federal Reserve to keep interest rates extremely low until the recovery is well established—no matter what's happening in asset markets.

With David Henry and Peter Carbonara in New York and Dexter Roberts in Beijing

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