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Should the Fed react to the stock market

The late 1990s witnessed the emergence of the greatest speculative bubble in financial market history. Investors bid up stock prices to unprecedented valuation levels as they extrapolated a temporary surge in corporate earnings growth far into the future.When these optimistic projections failed to materialize, the bubble burst, setting off a chain of events that eventually dragged the U.S. economy into a recession during 2001. In the aftermath of these events, a much-debated question is whether U.S. monetary policy should have reacted more aggressively to the parabolic run-up in stock prices. It has been argued that a policy of “leaning against the bubble” could have spared the economy from the long and painful process of unwinding bubbleinduced excesses.This Economic Letter examines the issue of whether central banks should react directly to asset prices. In addition, it presents empirical evidence which shows that lagged movements in the Standard & Poors (S&P) 500 stock index can help explain movements in the U.S. federal funds rate since 1987.