about the quality of corporate governance. * * * the struggle to understand developments in the economy and financial markets since the mid - 1990s has been particularly challenging for monetary policymakers. we were confronted with forces that none of us had personally experienced. aside from the then recent experience of japan, only history books and musty archives gave us clues to the appropriate stance for policy. we at the federal reserve considered a number of issues related to asset bubbles - - that is, surges in prices of assets to unsustainable levels. as events evolved, we recognized that, despite our suspicions, it was very committee on banking and financial services, u. s. house of representatives, july 22, 1999. for continuous discounting over an infinite horizon, k ( e / p ) = r + b - g, where k equals the current, and assumed future, dividend payout ratio, e current earnings, p the current stock price, r the riskless interest rate, b the equity premium, and g the growth rate of earnings. the relationship holds for both real and nominal variables. if k is assumed to be 0. 6, the average over the second half of the 1990s ( taking account of payouts made through share repurchases ), a rise in the p / e of the s & p 500 from 15 to 30, with r and b unchanged in real terms, implies an increase in g of 0. 02 in real terms. if earnings are a constant share of output in the long run, then real long - term earnings growth is the product of productivity growth and growth in labor force hours. in this exercise, the growth rate of hours, driven by demographics, is assumed not to change ; hence, the growth rates of earnings and productivity are the same. difficult to definitively identify a bubble until after the fact - - that is, when its bursting confirmed its existence. moreover, it was far from obvious that bubbles, even if identified early, could be preempted short of the central bank inducing a substantial contraction in economic activity - - the very outcome we would be seeking to avoid. prolonged periods of expansion promote a greater rational willingness to take risks, a pattern very difficult to avert by a modest tightening of monetary policy. in fact, our experience over the past fifteen years suggests that monetary tightening that deflates stock prices without depressing economic activity has often been associated with subsequent increases in the level of stock prices. for example, stock prices rose following

the completion of the more than 300 - basis - point rise in the federal funds rate in the twelve months ending in february 1989. and during the year beginning in february 1994, the federal reserve raised the federal funds target 300 basis points. stock prices initially flattened, but as soon as that round of tightening was completed, they resumed their marked upward advance. from mid - 1999 through may 2000, the federal funds rate was raised 150 basis points. however, equity price increases were largely undeterred during that period despite what now, in retrospect, was the exhausted tail of a bull market. 5 such data suggest that nothing short of a sharp increase in short - term rates that engenders a significant economic retrenchment is sufficient to check a nascent bubble. the notion that a well - timed incremental tightening could have been calibrated to prevent the late 1990s bubble is almost surely an illusion. instead, we noted in the previously cited mid - 1999 congressional testimony the need to focus on policies " to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion. " * * * it seems reasonable to generalize from our recent experience that no low - risk, low - cost, incremental monetary tightening exists that can reliably deflate a bubble. but is there some policy that can at least limit the size of a bubble and, hence, its destructive fallout? from the evidence to date, the answer appears to be no. 6 but we do need to know more about the behavior of equity premiums and bubbles and their impact on economic activity. 7 the equity premium, computed as the total expected return on common stocks less that on riskless debt, prices the risk taken by investors in purchasing equities rather than risk - free debt. it is a measure largely of the risk aversion of investors, not that of corporate managers. an increased appetite for risk by investors, for example, is manifested by a shift in their willingness to hold equity in place of psychologically less - stressful, but lower - yielding, debt. stock prices peaked in march 2000, but the market basically moved sideways until september of that year. some have asserted that the federal reserve can deflate a stock - price bubble - - rather painlessly - - by boosting margin requirements. the evidence suggests otherwise. first, the amount of margin debt is small, having never amounted to more than about 1 - 3 / 4 percent of the market