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The Fed’s policy of responding to asset price risk disregards the reality that behind the serial asset market Bubbles have operated a Credit system and Pool of Speculative Finance that, by its very nature, inflates only larger, more powerful, and increasingly destabilizing with each passing year of accommodation. Over time, as Bubble infrastructure and psychology become more entrenched, failure to "prick" the Bubble is to further accommodate it. As we have again witnessed during the past year, there are profound consequences to the Fed’s policy of ignoring Credit excess and resulting asset Bubbles. Moreover, incorporating into policy the intention of "appropriately dealing with the consequences" of asset Bubbles openly invites the by now dominating leveraged speculating community to aggressively position to profit from prospective rate cuts and "reflations."

I am personally a little sick and tired of the cop out nonsense that Bubbles can’t be identified until after the fact. If the focus were on Credit - where it should and must be -the analysis would become much less nebulous and the policy task much less ambiguous. When home mortgage debt growth accelerated from 1998’s 8.0% to 1999’s 9.4%, the Fed should have been on notice. When 2001’s 9.3% growth jumped to 2002’s 10.6%, they should have been on guard. When mortgage Credit then expanded 11.6% in both 2003 and 2004, there was no doubt that a problematic Bubble in Mortgage Credit had emerged, and the Fed should have aggressively tightened policy. Yet the Fed sat idly by and watched mortgage debt expanded a further 20% in two years, with resulting unprecedented Current Account Deficits, leveraged speculation, and global liquidity excess inspiriting speculative Bubbles in asset, securities and commodities markets across the globe.

Dr. Mishkin’s focus is misguided. The crucial question is not whether a bursting asset Bubble will lead to a severe episode of financial instability. Rather, the key issue is what impact a vulnerable or faltering asset Bubble has on the underlying Credit and economic systems. The extent to which stock market Bubbles have been fueled by underlying speculative leveraging and then exacerbated system Credit excess will dictate a major influence on the degree of financial instability one would expect in the event of a crash. At one extreme would be a stock market boom financed by minimal leveraged speculation within a generally sound Credit and economic backdrop. At the other end of the spectrum is the 1929 marketplace, with its gross speculative leveraging, acute financial fragility, and a deeply maladjusted Credit-driven Bubble economy. The '29 stock market Bubble closely intertwined with the system Credit Bubble. Somewhere between the two extremes is Japan in the late-eighties.

As we witnessed here at home, the bursting technology Bubble was met with surging bond and real estate prices. It triggered little in the way of severe tumult. Speculative leveraging in bonds and mortgage Credit growth provided more than ample system Credit and liquidity to sustain that unfolding Credit Bubble. Indeed, the tech bust and the Fed’s response only energized and emboldened the Credit system and leveraged speculator community. The ballooning Financial Sphere has been of late further empowered by the prospect of bursting housing Bubbles and the Fed’s foreseeable response. Not unpredictably, unprecedented Bubble Propagation enveloped the world.

Devastating Credit system crashes – fortunately much rarer events than bursting asset Bubbles – are the consequence of protracted periods of Credit and speculative excess. I would argue strongly that the mandatory backdrop demands repeated, extended, and escalating policymaker intervention and marketplace manipulation. Only such a constructive environment for prolonged financial excess can create such acute system fragility – unadulterated markets with functioning self-adjustment and correction mechanisms and dynamics would not. Regrettably, the Fed’s asymmetric strategy with respect to ignoring asset Bubble while they are inflating and then reflating aggressively when they falter is tantamount to flagrant market manipulation.

A Hippocratic Oath is in order: First of all, Federal Reserve monetary policy must do no severe harm. To live up to such an oath, monetary policy would strive to avoid fostering Credit and speculative excess, while being prepared to take all necessary measures to ensure that protracted Credit booms – with their deleterious effects on the financial and economic structure – not be tolerated. To minimize the risk of cumulative excesses and imbalances, the policy tool kit should avoid aggressive rate cuts, marketplace assurances, and commitments to respond to faltering asset markets. Monetary policy should not be used to stimulate the economy or asset markets – it must avoid being "activist." Absolutely never should the Fed use the leveraged speculating community as a reflationary and liquidity-creating policy mechanism. And never should the Fed pre-commit to inflationary policies in the event of bursting speculative Bubbles. Drs. Bernanke and Mishkin’s views on asset Bubbles and monetary policy are so dangerously ludicrous I find it difficult to believe they don’t provoke heated debate, some consternation, and at least a little outrage.

Doug Noland is a market strategist at Prudent Bear Funds. Their website is www.prudentbear.com.