Central banks should be ready to respond to events that could have systemic risks but should not try to prick asset bubbles with tighter monetary policy, San Francisco Federal Reserve Bank President Janet Yellen said on Friday.
It is exceptionally difficult to distinguish 'bubbles' from fundamental-based booms and monetary actions impose certain short-run costs for very uncertain future gains, Yellen said at a conference at Brandeis University's International Business School.
Speaking 10 years after the Asian financial crisis, Yellen said central bankers have the tools to curb dangerously fast-growing asset price spirals, notably by raising interest rates.
But she warned that any action must be implemented carefully and only after extensive analysis. The hurdle for doing something should be quite high.
Yellen, who is not a voting member of the monetary policy-setting Federal Open Market Committee in 2007, did not address the current U.S. economy or monetary policy but focused on conditions in global financial markets.
The United States, Yellen said, learned from Japan's experience and acted quickly several years ago to prevent the economy from losing too much steam when the U.S. stock market tumbled in the aftermath of the late-1990s Internet bubble.
Major aggressive steps were taken so the U.S. didn't end up where Japan ended up, she explained.
At the same time, the Fed's 12th District president said she was concerned that investors may be underestimating the risks in both the domestic and foreign markets.
There are many signs that risk premiums are notably low, including low yields available on long-term bonds compared with those for short-term debt, she said.
Long-term rates have risen in recent weeks, but not by nearly enough to resolve what former Fed Chairman Alan Greenspan coined 'the bond rate conundrum,' Yellen added.
She said tight spreads could reflect a genuine reduction of risk but a sudden reversal in risk perceptions cannot be ruled out.
Yellen spoke at a time defaults for risky mortgages are rising and after many Wall Street banks said woes in the subprime market would not hurt them even though they ultimately have.
The rapid rise of the subprime market may have reflected an unduly benign view of the underlying risks, and some lenders have paid a high price for this view, she said.
There is also some question whether supposedly sophisticated investors fully understand the investment strategies being pursued by hedge fund managers and the risks, Yellen said.
STRONG GLOBAL GROWTH STORY
Yellen said many aspects of the global economy were heartening and went beyond the blistering growth in China and India in 2006.
Importantly, growth was widely spread across most regions of the globe. At the same time, inflation was reasonably low among the advanced economies, and in most emerging market and developing countries it was quite moderate, she said.
Yellen expressed the Fed's typical concern about the large and growing U.S. current account deficit, calling the imbalance unsustainable.
A sudden unwinding of these imbalances could be associated with sharp movements in exchange rates and asset prices that could produce destabilizing economic impacts around the globe, she said.