The Fed Reserve seems to be moving towards implementing regulation and monetary policy shifts to stop asset bubbles from building up. In a series of comments by Federal Bank Governors, they have let it be known that preventing buildups like the dotcom and housing bubbles may become a priority for the Fed.

Ben Bernanke, current chairman, endorsed the Greenspan view in 2002 following the bursting of the dotcom bubble, though with the caveat that central banks should use microeconomic regulation to mitigate the risks caused by bubbles. Six years on, Mr Bernanke still believes it is hard to know when a bubble is a bubble. But he and other top officials are reviewing the Fed approach following the second big and disruptive bubble in a decade. One option would be for the Fed to tackle bubbles with monetary policy, setting interest rates higher than they would otherwise be when asset prices appear to be inflating beyond levels justified by economic fundamentals. Mr Bernanke rejected this approach in 2002 but is willing to re-evaluate it in the light of recent events.

Still, he and other top officials remain sceptical that "leaning against the wind" with interest rates is an effective strategy. They regard interest rates as a blunt tool for the job because they affect the economy and asset markets as a whole, not the specific market with a bubble. By contrast, there is widespread interest inside the Fed in using regulatory policy more aggressively to try to contain bubbles. Officials are intrigued by the extra possibilities that could be opened up by proposed new powers set out in a Treasury blueprint for regulatory reform. The Treasury recommends giving the Fed wide authority to require financial institutions to alter behaviour that it believes poses a threat to financial ­stability. - Fed looks at ways to fight asset bubbles, Krishna Guha, Financial Times, 13th May 2008

Forbes has extracts of a speech by Fed Governor Frederic Mishkin at the Wharton Business School Financial Risk Roundtable in Philadelphia. 'Monetary policy should not try to prick possible asset bubbles, even when they are of the variety that can contribute to financial instability,' he said. He joined a group of Fed officials that now includes Chairman Ben Bernanke and Minneapolis Fed President Gary Stern who are at least thinking about departing from the Greenspan doctrine. Former chairman Alan Greenspan insisted that central banks had no business trying to prick or prevent asset price bubbles, only to be prepared to clean up the mess after they burst.

Here's what Gary Stern said about attacking bubbles, from WSJ's Real Time Economics blog.
WSJ's Justin Lahart writes about 3 Princeton economists hired by then Professor Bernanke - Harrison Hong, Wei Xiong and Markus Brunnermeier - to study bubbles using mathematical methods.

When differences between bullish investors and bearish ones are extreme, many of
the bears simply move to the sidelines. Then, with only optimists playing, prices go higher and higher. In housing and the credit markets, the innovation was slicing and dicing loans in novel ways. As investors bought the resulting mortgage securities, they provided abundant capital for home buyers; buoyed by this and falling interest rates, house prices surged. Betting against house prices is hard; only a few sophisticated investors found roundabout ways to do it, in derivatives markets. Most skeptics about the housing boom just sat it out; the optimists were unchecked. At some point in a bubble, optimists' enthusiasm runs its course. Prices turn down. There's an expectation that at this point, investors who were skeptical may see prices as more reasonable and start buying. If they don't, that's a signal that prices had gotten way too high -- and then they tumble.

When a lot of borrowed money is involved -- as it often is in a bubble -- once prices peak, the speed of their fall is intensified as investors sell urgently to pay down debt. That pattern offers a strong argument, in Mr. Hong's view, for government to restrain bubbles and the borrowing that fuels them. - Bernanke's Bubble Laboratory, Justin Lahart, Wall Street Journal, May 16, 2008

And this is what Bernanke himself said in a speech in 2002 on Asset price "bubbles" and monetary policy. In this speech, Bernanke makes very detailed arguments both for and against Fed regulation to prevent asset bubbles. One of the points he makes is the difficulty in identifying bubbles and the fallout on growth if the Fed comes in too strong.

There's a green revolution in progress in Silicon valley right now, with investors pumping tens of millions into tiny startups who are producing and researching alternative energy devices and products. Like as not, it's a bubble building up, and a majority will fold up within a couple of years. But in the middle of that carnage could be a little gem of a startup which could come up with something amazing, and trigger a decade long bull run by freeing us from oil imports.
To understand this on a basic level, read this great article by Robert J. Shiller in the New York Times which explains how a post-bubble depression can cause an 'anti-bubble' where a downward cascade will develop — in which rational individuals become excessively pessimistic as they see others bidding down [home] prices to abnormally low levels.

Can the Fed walk this fine line and regulate bubbles without destroying innovation and investor confidence?