RPT-WRAPUP-Fed officials defend policies, see slow recovery

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By Mark Felsenthal and Pedro da Costa

ATLANTA Jan 3 (Reuters) - Top U.S. Federal Reserve officials defended policies leading up to the recent financial crisis, arguing that exotic mortgages and overconfidence in home price gains, not low interest rates, fueled a catastrophic housing bubble.

Addressing an economists' conference in Atlanta on Sunday, Fed Chairman Ben Bernanke said the U.S. economy is only now recovering from recession, and Fed Vice Chairman Donald Kohn warned the pace of recovery will be slow.

Bernanke said that vigorous financial regulation would have been the best way to restrain the housing boom that helped cause the deep recession but said policy makers can no longer rule out monetary policy to curb the buildup of risk.

In a speech defending the Fed's rock-bottom interest rates in the early 2000s, a policy some say spurred a surge in home values, Bernanke said the blunt instrument of rate hikes would have have been ineffective in checking the run-up in house prices.

Bernanke and the Fed face sharp criticism for failing to anticipate and prevent the crisis, even as he draws accolades for his handling of the meltdown. Bernanke's renomination as Fed chairman faces an unusual degree of opposition, and the Fed's responsibilities stand to be curtailed if congressional proposals become law.

SUPPLEMENTAL TOOL

Bernanke said, however, in a speech to the American Economic Association, that policy makers can no longer eliminate rate increases from their arsenal to prevent future crises.

"If adequate reforms are not made, or if they are made but prove insufficient to prevent dangerous buildups of financial risks, we must remain open to using monetary policy as a supplemental tool for addressing those risks," he said.

Bernanke conceded that efforts by the Fed and other regulators beginning in 2005 came too late or were insufficient to slow the housing bubble.

"The lesson I take from this experience is not that financial regulations are ineffective for controlling emerging risks, but that their execution must be better and smarter," he said.

The U.S. Senate is poised to begin debate over financial rules reforms that would peel away the Fed's authority for regulating large financial firms. The U.S. central bank would be charged instead with focusing on monetary policy.

Bernanke and other Fed officials have argued that such a change would hurt the Fed and oversight of the system in general by removing a crucial monitor from the pulse of the financial system.

KOHN: CREDIT STILL TIGHT

Bernanke said the economy is only just recovering from recession and what he called possibly the worst financial crisis in modern U.S. history.

The Fed has slashed benchmark rates to near zero and pumped hundreds of billions into the economy to nurse it through the meltdown and recession. Most analysts do not expect the Fed to begin raising rates until the middle of 2010 at the earliest.

The economy and job market will rebound only gradually because of ongoing constraints on lending, the Fed's Kohn told the same conference.

This means inflation will remain contained for some time, he said.

"Lingering credit constraints are a key reason why I expect the strengthening in economic activity to be gradual and the drop in the unemployment rate to be slow," Kohn said.

The U.S. economy expanded 2.2 percent in the third quarter but only after registering its worst recession since the 1930s.

Kohn said the Fed would have to begin pulling back, however, before things were completely back to normal.

"We will need to begin withdrawing extraordinary monetary stimulus well before the economy returns to high levels of resource utilization," he said.

Some analysts worry the Fed's ultra-accomodative policies could spur an unwelcome burst of inflation when the recovery solidifies. However, Bernanke repeated his expression of confidence the Fed is equipped to tap the brakes at the right time.

"We have a very robust strategy," he said in response to questions after his speech.

"It includes both raising the interest rate that we pay on reserves, plus a number of measures that we have been testing that will allow us to drain reserves from the system. So we're quite confident that we can constrain broader money growth and credit growth as needed to exit from these unusual policies when the time comes," he said.

Atlanta Fed President Dennis Lockhart did not comment on the outlook for the economy or interest rates in an appearance on a panel at the same conference. (Additional reporting by Joseph Rauch; Editing by Padraic Cassidy)