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UPDATE 1-Fed's Quarles says financial stability not main goal of monetary policy

Ann Saphir

policy@ (Adds comments on tradeoffs of using monetary policy to address financial stability risks, beginning in seventh paragraph)

May 30 (Reuters) - Federal Reserve Vice Chair of Supervision Randal Quarles reiterated on Thursday the U.S. central bank's longstanding view that macroprudential policies, not interest rates, are the central banking tool best suited to addressing risks to financial stability.

But at the same time he left open the possibility that raising rates to battle asset bubbles could be appropriate, warning that leaving monetary policy too easy for too long can create financial vulnerabilities.

While overall financial stability risks are currently not elevated, higher-than-usual business debt built up during the current near-record economic expansion could set the stage for worse outcomes in a future downturn, he said in remarks prepared for delivery to a New York Fed conference.

Even if the risk of financial system disruption does not seem high, Quarles said, "if the economy weakens, some businesses may default on this debt, potentially leading to a contraction in investment, a slowdown in hiring, and possibly to an unusual tightening in financial conditions."

Still, he said, "while there is evidence that financial vulnerabilities have the potential to translate into macroeconomic risks, a general consensus has emerged that monetary policy should be guided primarily by the outlook for unemployment and inflation and not by the state of financial vulnerabilities."

Quarles did not speak to his current outlook for the economy or interest rate policy in his prepared remarks, though their thrust suggested he is not a supporter of the rate cut in coming months that traders of short-term interest rate futures are currently betting on.

Financial stability must be a consideration in monetary policy, he said, to the extent that it affects jobs and prices, the dual focus of Fed policy under its legal mandate. But trying to promote financial stability through monetary policy can do more harm than good, he said.

"At the same time, some research has identified circumstances under which the benefits of using monetary policy to lean against financial vulnerabilities could outweigh the costs," he said, particularly given the large economic losses that result from a financial crisis. "We do not fully understand the costbenefit tradeoff and whether monetary policy adjustments for financial stability reasons may be appropriate at some times." (Reporting by Ann Saphir Editing by Paul Simao and Chizu Nomiyama)