Policy has only limited use in pricking bubbles: US Fed's Mester

Loretta Mester James McAndrews
David Stubbs | Reuters

The Federal Reserve should not rush to raise interest rates to head off risky financial market bubbles because its usefulness remains "debatable" and other, more direct tools of regulation are superior, a top U.S. central banker said on Friday.

Cleveland Fed President Loretta Mester said these direct "macroprudential" tools should be the central bank's first line of defense against financial excesses that threaten the economy, and that monetary policy should be used only if they fail and risks are growing.

With the comments, Mester, the Fed's newest policymaker, waded into the debate over whether the central bank should proactively prick bubbles in areas such as mortgage markets or leveraged loans, or whether it should only adjust rates based on its formal inflation and employment goals.

"I would opt to use the macroprudential tools as the first line of defense, since they can be more targeted to the markets and institutions where the risks are emerging," she told a financial stability conference. "Whether monetary policy would be as effective is debatable. While interest rates affect the fundamental value of assets, it is not clear they affect the speculative or bubble portion."

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Since the Fed was caught flat-footed in the financial crisis, policymakers have paid more attention to signs that asset prices are threatening the broader economy, which has been slowly recovering from recession.

Mester, who has a vote on policy this year under the Fed's rotating system, said the central bank must assess growing risks to stability, not whether there is a bubble.

"In a situation in which the macroprudential tools proved to be inadequate and risks to financial stability continued to grow, monetary policy should be on the table as a possible defense," she added.