Monetary policies may need to be "more accommodative than otherwise" in the wake of financial crises that impair a central bank's ability to nurture the real economy, an influential Federal Reserve policymaker argued on Monday.
In his first public comments since the Fed last week unveiled a plan for reducing its stimulative asset purchases, New York Fed President William Dudley said the U.S. central bank must consider financial instability when formulating its policies.
Dudley did not comment specifically on the Fed's current policy stance. Instead he spoke more generally about the intersection of financial regulation and monetary policy, and he largely repeated past arguments.
"The stance of monetary policy needs to be judged in light of how well the transmission channels of monetary policy are operating," Dudley said according to prepared remarks to the Bank for International Settlements, in Basel.
"When financial instability has disrupted the monetary policy transmission channels, following simple rules based on long-term historical relationships can lead to an inappropriately tight monetary policy."
The Fed set off waves of selling in the world's financial markets when Chairman Ben Bernanke said on Wednesday the U.S. central bank expected to reduce its bond-buying later this year and halt the stimulus program altogether by mid-2014 if the economy improves as forecast.
As it stands, the Fed is buying $85 billion in Treasury paper and mortgage-backed securities each month to stimulate investment, hiring and economic growth. Policymakers also mostly expect to keep benchmark interest rates near zero until 2015.
Dudley is a close ally of Bernanke and a strong backer of the Fed's unprecedented efforts to accelerate the U.S. recovery from the 2007-2009 financial crisis and recession.
His comments gave a brief boost to U.S. bond markets early on Monday, though the price of the benchmark 10-year Treasury note was down again in morning trading.
Dudley repeated that the Fed has fallen short of its employment and inflation objectives.
"This suggests that with the benefit of hindsight, U.S. monetary policy, though aggressive by historic standards, was not sufficiently accommodative relative to the state of the economy," he said.
"In this regard, I would caution against the mechanical use of monetary policy rules following a financial crisis," he added, noting the so-called Taylor Rule guide for policy-making should not be followed blindly.
The Taylor Rule governs the relationship between economic slack and inflation, and assumes a 2.25-percent real interest rate when policy is neutral. But Dudley said that rate is likely "considerably lower" if financial instability is impairing the effectiveness of Fed policy.
"Monetary policy needs to take this onboard," he said.
In the depths of the 2008 financial crisis, the Fed extended several emergency lending facilities into the financial system, brokered mergers of major banks, and absorbed onto its balance sheet the assets of American International Group.
Though the central bank was blamed for missing early signs of the crisis, U.S. lawmakers later increased its responsibility for financial supervision.
The Fed "needs to be willing to respond to limit financial market bubbles from developing in the first place," Dudley said. To do so the Fed can impose rules on financial firms, adjust monetary policy, or use "the bully pulpit," he added.
(Reporting by Jonathan Spicer; Editing by James Dalgleish and Chizu Nomiyama)