Speaking today at the New York Economic Club in New York City, New York Federal Reserve President William C. Dudley shared his opinion that central banks should take a more active role in fighting asset bubbles.

“As I see it, we need to reexamine how central banks should respond to potential asset bubbles. After all, recent experience has underscored the fact that poorly regulated financial systems are prone to such bubbles and that the costs of waiting to respond to an asset bubble until after it has burst can be very high.”

Dudley goes on to argue why he believes asset bubbles exist and what may be done to combat them. Defining an asset bubble as, “…price increases (or declines) that become unmoored from fundamental valuations,” the NY Fed President goes on to illustrate how these are difficult to spot, but that they have several common characteristics. Several examples of bubbles over the past 30 years are given, including the U.S. Dollar in the 1980’s, the technology bubble in the late 1990’s and the recent housing bubble.

We are also informed of what may be done to locate and combat these asset bubbles:

So what should the policymaker do? I think the first step is for the policymaker to work hard to investigate what is generating the sharp rise in prices for the asset in question. Sustained price increases are a symptom of changes in demand and supply. The policymaker needs to develop a perspective about whether these demand and supply changes are realistically sustainable to the extent implied by market prices. In particular, carefully analyzing the assumptions that underpin sustained increases in asset prices—which might be symptoms of a bubble—and considering the risk that these assumptions might be wrong is important. Also, looking carefully at the dynamics of the system on which the beliefs are based may be useful. In particular, are the dynamics of the system reinforcing or dampening? If the dynamics are reinforcing, then there is greater likelihood of an asset bubble.

The next step is for the policymaker to evaluate what tools might be available to curb the imbalances that have been identified. The idiosyncratic nature of the innovations and belief systems associated with particular bubbles implies that the tools used to respond to each bubble will likely have to be different and tailored to the features of the particular bubble in question.

Finally, the policymaker needs to conduct a careful cost-benefit analysis, weighing how successful a particular policy might be in restraining the rise in asset prices versus how costly it would be to remain passive, letting the bubble grow and then potentially burst disruptively. Many factors will affect the outcome of this analysis including the magnitude of the potential asset bubble and whether the potential asset bubble is occurring in the equity or debt markets.

Given the track record of policymakers when it comes to identifying and combating past bubbles, one wonders if this is a feasible strategy.