FED FOCUS-Hot money puts focus on central bank asset views

NEW YORK Nov 16 (Reuters) - A surge of speculative cash into overseas markets has sharpened a debate among central bank officials on how best to rein in asset prices when it appears a bubble may be building.

The stakes are high. Liu Mingkang, a senior Chinese regulator, warned on Sunday that ultra-low interest rates in the United States are fueling speculation in overseas asset markets and threatening the global economic recovery.

Before the housing bust, the Fed and other major central banks advocated a hands-off approach to asset prices, arguing it is easier to clean up the mess after a bubble burst than to spot and stop it preemptively.

But the U.S. housing bubble and the pain its bursting inflicted on the global economy reshaped discussion in central banks around the world, and officials are grappling with how asset prices should play into policy decisions.

San Francisco Federal Reserve Bank President Janet Yellen, who votes on the U.S. central bank's policy-setting Federal Open Market Committee, said the crisis had changed her mind on the weight policymakers should assign asset prices.

"We should be monitoring asset prices for signs of bubbles," Yellen said last week. "My views on that have changed because of the crisis."

European Central Bank Governing Council member Axel Weber said earlier this month that the financial crisis taught central bankers they cannot afford to ignore wild asset price developments.

But while a consensus appears to be building that asset price developments can't simply be disregarded, what to do once red flags emerge is still a tricky issue. Fed officials have said they do not see asset bubbles brewing now, even though global stocks have risen more than 70 percent since March.

INTEREST RATES OR REGULATION?

Some officials have expressed openness to "leaning against" asset bubbles with monetary policy, while others say that this can do more harm than good, arguing that regulatory tools would be more targeted and effective.

James Bullard, president of the St. Louis Federal Reserve Bank and an FOMC voter in 2010, told the Financial Times that the Fed might take into account the danger that ultra-low rates could fuel asset price bubbles in its decision of when to tighten policy.

Are you "generating the conditions that might foster a bubble that really might come back to hurt you later? I think this will be a big issue for the committee," Bullard said.

Under former Fed chairman Alan Greenspan, a key proponent of the mop-up-later approach, the U.S. central bank kept the benchmark overnight lending rate at 1 percent for a year from 2003-2004 and then hiked slowly. Analysts say this policy laid the groundwork for the housing bubble.

Still, the Fed is likely to be loath to try to dampen a rise in asset prices unless it believed a leverage-fueled bubble was building whose bursting could unleash another financial firestorm in the United States.

A number of officials, including Chicago Fed President Charles Evans and New York chief William Dudley, maintain that interest rates are too blunt a tool to combat asset bubbles.

Fed Chairman Ben Bernanke has made that case as well. As a Fed governor in 2002, he likened using monetary policy to pop bubbles as trying "to perform brain surgery with a sledgehammer."

At the height of the financial maelstrom last year, he said officials would have to rethink their approach, but like Evans and Dudley he advocates regulation and supervision as a way to rein in excessive risk-taking.

This is also the approach some Asian countries have taken.

Singapore in September acted to cool the property market by releasing more land and making it harder for home buyers to defer payments. [ID:nSIN486658] Hong Kong's central bank has said it would cap the mortgage limit for luxury property at 60 percent and limit loan values. [ID:nHKG305705]

Central banks face a difficult task in determining how to communicate their approach to asset prices. They have to be careful to make the distinction between "monitoring" prices and the more explicit "targeting," which could act as a straitjacket for policy, analysts said.

The ECB's Weber said in early November that preventing bubbles should not become an explicit aim of monetary policy the way consumer inflation is.

Central bank officials have also expressed unease at being expected to decipher in real time whether a rapid rise in asset prices is due to potentially destabilizing overvaluation.

POLICY HEADACHE?

Whether they turn into bubbles or not, the increasing disconnect between risky asset class valuations and the broader global economy has the potential to become a policy headache.

Policymakers do not expect a strong "V"-shaped economic recovery. However, stock markets seems to be in a strong rebound.

Frederic Mishkin, a former Fed governor, wrote in the Financial Times last week that not all bubbles are created equal and the current run-up in asset prices is not a reason for the Fed to raise interest rates sooner.

There is a difference between an "irrational exuberance bubble" -- such as the U.S. technology stocks bubble in the late 1990s -- and a credit bubble, he argued.

"The 'pure irrational exuberance bubble,' is far less dangerous because it does not involve the cycle of leveraging against higher asset values," Mishkin wrote.

"Without a credit boom, the bursting of the bubble does not cause the financial system to seize up and so does much less damage," he said. (Editing by Kenneth Barry)