N.Y. Federal Reserve Chief Says Central Bank Should Target Bubbles

By Michael McKee
Bloomberg News
Saturday, July 4, 2009

The Federal Reserve should break with past policy and try to identify and deflate asset bubbles before they can damage the U.S. economy, New York Federal Reserve President William C. Dudley said.

While interest-rate policy may not be the appropriate tool for popping bubbles, Fed officials have "other instruments in their toolbox," Dudley notes in the text of a speech scheduled for July 26 at the Bank for International Settlements in Basel, Switzerland. The New York Fed released his remarks yesterday.

The Fed's view has been that bubbles can be identified only in hindsight, and that all the central bank can do is prepare to clean up after they burst. The current crisis shows that policy is mistaken, Dudley said.

"Asset bubbles may not be that hard to identify," he said. "This crisis has demonstrated that the cost of waiting to clean up asset bubbles after they burst can be very high."

Dudley did not specify what tools the Fed should use. Analysts have suggested that central bankers might raise reserve requirements or amp up restrictions on margin lending.

Central bankers could also comment publicly on asset price levels, trying to "jawbone" markets lower, as former Fed Chairman Alan Greenspan did with his comments on "irrational exuberance" in December 1996.

Dudley did not discuss the current economy or monetary policy in his remarks, which deal with lessons learned in the financial crisis.

Additionally, supervision of financial firms must take into account how interconnected banks, markets and payment systems are, he said.

"Supervision must not just be vertical -- firm by firm or region by region -- but also horizontal, looking broadly across banks, securities firms, markets and geographies," Dudley said.

To accomplish that, the systemic-risk regulator proposed by the U.S. Treasury must have the right tools, culture and legal powers, he said.

"But we shouldn't kid ourselves about how difficult this will be to execute," Dudley said. "You will need a flexible and dynamic governance process to be able to identify the important elements of systemic risk, to elevate those concerns to the appropriate level and then to act on those concerns in a timely manner."

Regulators must also work to limit what Dudley called reinforcing and damping mechanisms that exacerbate financial crises.

Collateral tied to credit ratings, faulty risk-management, compensation programs that provide incentives for risk-taking, and the desire of institutions to pay capital-depleting dividends fall in those categories, he said.

"We might want to engineer out of the financial system [that] bad outcomes are not just about bad luck, they are also about bad incentives," the speech says.

In one idea, supervisors would compel financial firms to hold additional capital in the form of debt instruments that would be converted to equity if share prices fell "dramatically."

The Supervisory Capital Assessment Program, which stress-tested the 19 largest U.S. banks, was successful in forcing lenders to face up to their capital needs and should be repeated "on a systematic basis," Dudley said. "Such exercises may need to be hard-wired into the oversight of the financial system."

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