. a few months following y2k, the stock markets began the steep decline that has reversed much of the remarkable rise witnessed over the latter half of the 1990s. that decline has been one source of the weakness that has undermined the expansion of the economy over the past two years. in recognition of that experience, many have characterized the extraordinary rise in stock prices in the late 1990s as a bubble - a significant and protracted departure in asset prices from fundamentals - and the subsequent decline as a popping of that bubble. our recent experience has given renewed spark to a vigorous debate about the appropriate response of monetary policy to financial bubbles, with some economists criticizing the federal reserve for not having done more to stem the expansion of the bubble. economists agree that bubbles can impair the functioning of the economy by promoting a misallocation of resources when they are inflating and by provoking severe dislocations when they pop. but because we are talking about economists, you can be sure their opinions differ substantially after that. one branch of economists holds the view that monetary policy should not be influenced by any perceived financial market bubbles. an extreme version of this view is that bubbles probably do not exist - that rational market processes always price assets at their fundamental value. a more moderate version is that even if bubbles do exist, they cannot reliably be identified, and even if bubbles can be identified, we do not know how they respond to monetary policy. the extreme view at the other end of the spectrum holds that central banks should pop bubbles as soon as they can. according to this view, by raising interest rates when a bubble begins, the central bank can avoid the volatility that occurs when a bubble fully inflates and then pops. central bankers need to be practical, not extreme, and consequently my view falls somewhere in between. on the one hand, i am skeptical that central bankers or anyone else can accurately identify bubbles as they are inflating, and i know of no central banker who understands with great certainty how bubbles respond to monetary policy. on the other hand, the fomc does attempt to take into account the effect of asset values on the economy when setting interest rates and does consider the likely reaction of asset prices to our policy decisions. another type of financial instability that can influence monetary policy in a way that is very difficult to embed in a rule occurs when important intermediaries - banks, securities dealers, hedge funds - fail or when markets seize up in a financial

roger w ferguson, jr : rules and flexibility in monetary policy speech by mr roger w ferguson, jr, vice - chairman of the board of governors of the us federal reserve system, at the university of georgia, athens, georgia, 12 february 2003. * * * thank you for honoring me with this opportunity to deliver a charter lecture. as you know, these lectures are designed to commemorate the high ideals highlighted in the charter that established the university of georgia in 1785. in broad terms, the charter defines some of the fundamental objectives for this university, including working to foster an informed public and thereby promoting an effectively functioning democracy. in addition, the charter describes the key instrument by which the university is to pursue these objectives - namely providing higher education to the public. the charter is also notable for what it does not describe. it does not, for example, lay out a rigid curriculum that all students must complete. the founders no doubt recognized that the university would need a degree of flexibility in designing its programs to suit the needs of a changing student body and changing times. as it happens, academics as well as practicing central bankers around the world have devoted a great deal of thought over the past ten to twenty years to defining the goals and objectives that should be included in central bank charters and also to describing how central banks should go about achieving these goals. in many ways, this discussion has led to a fair degree of consensus around a model similar to that embodied in the university of georgia charter ; that is, central bank charters should clearly state key objectives and describe in general terms the tools that central banks can use to pursue those objectives. however, central bankers, like educators, require some flexibility in applying their tools in order to respond appropriately to changing circumstances over time. the emergence of sustained inflationary pressures in the 1960s and 1970s and central banks'long and difficult struggle to combat these pressures helped forge this consensus. inflation began to drift higher during the vietnam war and flared into double digits following the sharp increases in oil prices in the middle and late 1970s. although snapping the inflationary spiral was painful for our nation - the recession of the early 1980s was the deepest since the great depression - the subsequent prosperity in terms of income growth and economic stability has been unprecedented. the experience deepened the conviction of many economists and central bankers that economic policies that push an economy to operate beyond its long - run potential to produce inevitably lead to rising rates of inflation. moreover, the strong economic performance of the u. s. economy following the tam