How Did the Fed React to the 1990s Stock Market Bubble? Evidence from an Extended Taylor Rule

How did the Federal Reserve Bank react to the stock market bubble of the late 1990s? At a Symposium sponsored by the Federal Reserve Bank of Kansas City in Jackson Hole, Wyoming on August 30, 2002, Chairman Alan Greenspan remarked that economists do not currently have a way to measure a stock market bubble convincingly. He also argued that in the absence of such a measure, it was difficult for the Fed to justify, with some degree of certainty, a preemptive tightening that would likely be necessary to neutralize such a bubble. This paper extends the Taylor Rule methodology to include three measures of stock market overvaluation and confirms Greenspan's statement that the Fed did not neutralize the bubble. However, the extended Taylor Rule methodology also shows that the Fed, perhaps unintentionally, by keeping the Fed funds rate below those suggested by the Taylor Rule, may have actually contributed to the growth of the bubble.