But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?
By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives.
The recent period has been marked by a transformation to an economy that is more productive as competitive forces become increasingly intense and new technologies raise the efficiency of our businesses...While these tendencies were no doubt in train in the "old," pre-1990s economy, they accelerated over the past decade as a number of technologies with their roots in the cumulative innovations of the past half-century began to yield dramatic economic returns.
It seems superfluous to constrain trading in some of the newer derivatives and other innovative financial contracts of the past decade. The worst have failed; investors no longer fund them and are not likely to in the future.
Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?
We cannot rule out a situation in which a preemptive policy tightening becomes necessary, ... Such caution seems especially warranted with regard to the sharp rise in equity prices during the past two years. These gains have obviously raised questions of sustainability.
