Fed's Mishkin: Rates not for popping asset bubbles

PHILADELPHIA (Reuters) - Central banks should not try to burst asset bubbles with interest rates, but regulations aimed at preventing the market failures that can inflate them may help reduce their size and impact on the broader economy, Federal Reserve Governor Frederic Mishkin said on Thursday.

"Just as doctors take the Hippocratic oath to do no harm, central banks should recognize that trying to prick asset price bubbles using monetary policy is likely to do more harm than good," Mishkin said in a speech at the Oliver Wyman Institute in Philadelphia.

While he said the bursting of the U.S. housing bubble and the damage done to households' credit has been a drag on the economy, Mishkin added that interest rates are too blunt a tool for targeting sharp rises in specific asset prices.

Policy-makers should instead focus instead on changes to inflation and employment, he said.

"This point of view implies that actions such as attempting to prick an asset price bubble should be avoided," he said.

Aggressive interest rate increases by the Fed in 1929 and the Bank of Japan in the late 1980s hurt the U.S. and Japanese economies, respectively, while failing to puncture price bubbles.

Not all bubbles are alike, though, Mishkin said, and he did acknowledge that credit-led boom cycles, such as one in the U.S. housing market driven by loose lending standards, present a potential threat to the financial system.

With monetary policy focused on ensuring price stability and sustainable employment, "it falls to regulatory policies and supervisory practices to help strengthen the financial system and reduce its vulnerability to both booms and busts in asset prices," he said.

And while he said central bankers are no better equipped than investors to identify a stock market bubble such as the one that gripped technology stocks in the 1990s, they may be better positioned to flag one driven by a credit boom.

In such cases, policy makers may be able "to consider implementing policies to address the imperfections behind the market failures and thereby help reduce the magnitude of the bubble," he said.

Regulators or central bankers may be privy to information showing lenders have weakened their underwriting standards, he said which would spark an excessive expansion of easy credit.

"Our approach to regulation should favor policies that will help prevent future feedback loops between asset price bubbles and credit supply," Mishkin said on Thursday.

Such feedback loops occur when rising asset values encourage lending against those assets, increasing prices further and then prompting lenders to relax credit standards on the view that the asset appreciation mitigates the risk.

Earlier this decade, with the U.S. economy reeling from the collapse of technology stocks and the September 11 attacks, record low interest rates and easy lending standards inflated just such a feedback loop in housing.

But as interest rates started to rise and home prices to fall, an increasing number of less creditworthy borrowers began defaulting, sparking losses at financial institutions that had invested in bonds backed by these subprime mortgages.

The Fed has cut benchmark interest rates by 3.25 percentage points to the current 2 percent since September to help the economy weather the fallout.