Published: Tuesday, 17 Nov 2009 | 12:18 AM ET

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The Federal Reserve's low interest rate policy is meant to encourage investors to move into riskier assets in order to promote economic recovery, and there are no signs currently the policy is resulting in the build-up of a U.S. asset bubble, the central bank's number-two official said on Monday.

Donald Kohn

Fed Vice Chairman Donald Kohn said the recent rise in asset prices reflects several factors: the reversal of the "extreme panicky conditions" of late 2008, the turnaround in economic prospects, and ultra-low interest rate policies in the United States and other key economies.

Many investors, scarred by the damage wrought by the bursting of the housing bubble, are wary of the potential of new bubbles building as a result of ultra-low interest rates in key countries.

Kohn underscored why the low rates are critical to an economic recovery.     

"One of the purposes of these policies is to induce investors to shift into riskier and longer-term assets in order to lower the cost and increase the availability of capital to households and businesses," Kohn said at an event co-sponsored by the Kellogg School and Northwestern University.

The resulting easier credit is designed to encourage spending during a period when output is expected to remain well below the economy's capacity for a prolonged period, he said.

The Fed lowered the overnight federal funds rate to near zero percent last December and has kept it there since. After its last policy meeting in November, the U.S. central bank reiterated its expectation that rates could be kept unusually low for "an extended period."

Kohn said it is difficult for policy makers to spot asset price bubbles, but said prices in U.S. financial markets "do not appear to be clearly out of line with the outlook for the economy and business prospects, as well as the level of risk-free interest rates."

A recent 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.

Kohn said that current circumstances illustrate the complications of using monetary policy as ammunition against a potential bubble.

"Tightening financial conditions at a time when an economic recovery has just begun, when labor markets are continuing to weaken, when inflation is below its optimal level for the longer run, and when significant strains persist in the financial system would incur a considerable short-run cost in order to achieve possible long-run benefits whose extent is, at best, quite uncertain," he said.

That said, the Fed needs to "be alert to any tendencies for movements in prices for commodities and assets to result in a sustained increase in inflation and inflation expectations," he said.

Kohn, like Fed Chairman Ben Bernanke earlier on Monday, said monetary policy was a blunt tool for tackling asset bubbles and that using supervision and regulation may be more appropriate.

Given "the side effects of using policy for this purpose, and other difficulties, such circumstances are likely to be very rare. I continue to believe that the best approach is to strengthen supervision and regulation," Kohn said.

Another challenge for policy makers in tackling asset bubbles is the timing, Kohn said. Central banks would need to spot threats very early -- when it would be especially difficult to determine whether asset prices are overvalued or not.

Kohn also addressed whether some of the tools the Federal Reserve developed in its battle against the financial crisis should be made permanent.

He said a pending question was whether the Term Auction Facility -- a facility for banks to anonymously tap central bank credit -- and liquidity swaps lines with foreign central banks should be made permanent.

Kohn, at a time when proposals in Congress seek to curtail the Fed's powers, also stressed the importance of the central bank being the lender of last resort in a crisis.

"Lending in support of markets and classes of important intermediaries becomes an essential extension of monetary policy to foster our legislated mandate of promoting maximum employment and stable prices," he said, adding that the Fed's ability to preserve financial stability could be enhanced by ensuring it has the ability to lend to non-banks in emergencies.

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