Backstopping the Economy Too Well?

More specifically, the perception also results from the Fed's decisions to slash interest rates in response to a series of economic shocks over the last seven years -- thereby pumping cheap money and, some say, overconfidence into the markets. The shocks include the 1998 bond market turmoil sparked by a hedge fund's huge losses; the 2001 recession and terrorist attacks; and the fear in 2003 that falling inflation might turn into deflation, a harmful drop in the overall price level.

The Fed has been raising short-term rates gradually over the past year. Nevertheless, critics argue it should move more aggressively today and in the months ahead to curb various excesses they see:

· The surge of money into hedge funds, the lightly regulated and often heavily leveraged private investment funds for wealthy investors willing to take greater risks in search of greater returns. The amount under hedge fund management has grown to more than $1 trillion this spring from nearly $200 billion at the end of 1995, according to Hedge Fund Research Inc., a Chicago-based research firm.

· Soaring home prices. The value of all U.S. household real estate rose 15 percent in the first three months of the year from a year earlier -- faster than the growth in after-tax income, according to the latest Fed data.

· Real estate speculation. The National Association of Realtors estimates that 23 percent of U.S. homes purchased last year were for investment. Another 13 percent were second homes. About 23 percent of home buyers nationwide are using interest-only loans, according to LoanPerformance, a company that tracks loan originations. Interest-only and other types of adjustable-rate mortgage loans allow borrowers to pay no principal and sometimes little interest for an extended time while gambling that home prices will keep rising.

· The low interest rates paid on many types of debt issued by developing countries and shaky companies. One measure of risk in financial markets is the difference, or "spread," between the rates paid on such debt and the yields on ultra-safe U.S. Treasury securities. Such spreads have been tight this year, hitting lows not seen since before the Asian financial crisis of 1997 and 1998.

Fed officials share a concern about these developments but attribute them largely to a combination of Fed policy and complex global trends that have pushed down inflation and long-term interest rates worldwide for many years. This has helped stabilize the U.S. economy, resulting in milder, less frequent recessions.

People may be taking more financial risks because they reasonably expect the economic waters to remain calm, Greenspan suggested in his February report to Congress:

"In the United States, only five quarters in the past 20 years exhibited declines in [economic output] and those declines were small. Thus, it is not altogether unexpected or irrational that participants in the world marketplace would project more of the same going forward."

He added, however, "history cautions that people experiencing long periods of relative stability are prone to excess. We must thus remain vigilant against complacency."

Greenspan also said recently that the nation's housing boom is an unintended but acceptable side effect of the Fed's efforts to support the economy through difficult times. He and other Fed officials reject suggestions that they overreacted in cutting interest rates following the bursting of the stock market bubble in 2001.

"As best we can judge . . . the positive effects of the policy far exceeded the negative ones," Greenspan told Congress's Joint Economic Committee earlier this month. "And while it's too soon to judge the final conclusions of how all this comes out, I think that given the same facts under the same conditions, we would have implemented the same policy."