Asset bubbles have been familiar in the American economy for over a century, but over the last several decades they have gained new prominence.  During these years inflation has also been near a historic low, and the Fed, especially under Allen Greenspan, took the credit, at least until the bubbles burst, notably after the "dot-com" stock market bubble and particularly after the bursting of the housing bubble.  But this raises an interesting question- how could inflation be so low during times of rapidly rising prices?  Housing, which represents a quarter of the Consumer Price Index (a third if all components of housing are included) saw prices nearly double on a national level, and yet tis huge increase was never reflected in the inflation rate, and money was kept cheap and poured into the sector.

An asset bubble is supposedly an abomination to a perfectly efficient market- it means that people are investing resources into assets that are over priced.  Proponents of the idea that markets are optimally efficient usually find a way to skirt around this point, but the simple fact is that people drive bubbles and people are driven by emotion, greed, and irrational expectations.  The efficient economist wants to find a way to prevent these irrational bubbles without expensive (and often easily bypassed) regulation that can impede other market mechanisms that ARE efficient.  To do that we have to see what it is our economic system that allows these bubbles to form in the first place.  So lets start with the Fed.

The Federal Reserve is the national (in many regards the global) central bank.  Among its jobs are setting the over night lending rate and defending the value of the currency.  Setting the over night rate is key- most longer term rates are tied directly or indirectly to this rate.  The rate is also an aspect of defending the currency- a higher rate means a higher rate of return for lending money to the US financial system (or paying more for borrowing dollars).  Fighting or preventing a high rate of inflation is the first job of the Fed in defending the dollar.  When prices start to rise the response of a currency defending Fed should be interest rate hikes.  

But what if prices can rise that are invisible to the Fed?  The Fed has a range of tools and measures to calculate inflation which it uses to set interest rate policy.  Here is a simple fact of economics- it is not as hard a science as economists would like it to be (particularly quantitative economists) and the tools and measurements used to calculate inflation have aspects to them that are quite subjective.  This subjectivity takes several forms- what prices are included in the index and what are left out and how much a price is "weighed" in the overall calculation, and finally how a price is actually measured.  

Over the years these tools and measures have been tweaked and modified as the central bank has attempted to get a grip on how best to measure inflation in an economy that has a constant churn of products, technologies, consumer behaviors and preferences, and economic structures. Health care, for example, is under weighed in the measure of inflation.  It accounts for only 6% of the weight of the CPI even though it accounts for nearly a fifth of GDP.  There is no measure of inflation is the stock market, even though a large fraction of consumers buy stocks and other equities through mutual funds and retirement accounts with every paycheck.  And housing.  Housing is measured by what is called "Owner equivalent rent".  What this means is that the monthly cost of housing is not measured by the mortgage payments, but what price comparable housing would cost to rent.  This belies a simple fact- buyers and renters do not compete in the same market.  The inefficiency of the measure is, over the past few years, quite apparent- housing prices can double, but if rental rates do not follow suit the resulting measure of inflation in the housing market (or "shelter" as it is referred to in the CPI) is flat.  (On another note, the use of "substitution" in computing inflation, ie- switching from the cost of beef to the cost of chicken, is not a real measure of inflation in any meaningful way.  It is essentially a way to say that so long as the American consumer will continually allow for a diminishing quality of life he or she will not have to read that inflation is higher than might be politically comfortable).  

So here we have the Federal Reserve, defender of the American currency and inflation watchdog, keeping guard with what are some rather large blind spots.  In these blind spots inflationary pressures can rise up in the form of price (or asset) bubbles that for a while give a positive economic spin to what is in fact an underlying econometric weakness.  When these bubbles burst the result is lost investment capital, an a re-allocation of economic resources to more efficient and productive uses that must try and make up for the capital lost to the bubble and earn a decent return on top of it (lately though, money has gone into anther bubble, there by exacerbating the process).  This is not only inefficient but expensive, wasteful and destructive.  

So, the efficient economist would like a solution that can kill as many birds with as few stones as possible.  In this scenario, the solution is obvious.

The measure of inflation must be expanded to include those aspects of the economy that have seen inflationary price bubbles.  Housing prices must be accommodated more robustly to move beyond the easy to measure "owner equivalent rent" to include purchase costs.  A new component should be added (or a separate index created) to measure inflation in the stock market. 

This, though, is still a less than efficient solution to preventing bubbles in the economy.  The efficient economist would ideally like to see interest rates tied to the rate of inflation that is present in a particular market rather than to the inflation rate of the whole economy.  If housing prices are booming in Maine then interest rates on home loans in Maine should ratchet up while those else where reflect their own local scenarios. 

The case for a more flexible interest rates runs into a number of legal issues.  Speculators, as well as legitimate suppliers and developers, will argue that such an arrangement runs against their legal rights to profit.  The best counter I can see to this complaint would be along these lines:  If you were sharing a boat with another person, would you want to protect their right to profit by selling the the planks?  At some point the protection of the greater good must outweigh that of individual benefit, and those involved in speculation as opposed to actual development and value-added economic activity should be kept on a shorter financial leash, if not for their own sake than for that of their clients.

resources:  http://www.bls.gov/cpi