RTTNews - Minneapolis Federal Reserve Bank President Gary Stern praised the Fed's policy response to the financial crisis Tuesday, although he suggested that additional work needs to be done in the areas of too big to fail and intervention in asset bubbles.

Speaking at the Willmar Lakes Area Chamber of Commerce in Minnesota, Stern praised the Federal Reserve's response to the crisis, calling its aggressive policy response the reason that conditions in credit markets have generally improved.

While it is still too early to fully tally results, there has been progress, and I anticipate further improvement in credit conditions as select programs become fully operational, participation increases, and confidence picks up, Stern said in prepared remarks.

However, despite the best efforts of the Fed the financial system remains impaired, Stern warned.

Resurrecting the impaired financial system to restore a healthy, smoothly functioning system is essential for a full economic recovery, Stern said.

He noted that some markets remain closed, unable to price the financial instruments that normally trade on them. Barring an improvement in credit conditions, these market disruptions threaten to prolong the recession, Stern warned.

In addition, Stern called for a healthy banking system, helping to mitigate the problem of overwhelming demands on the banks from nonbank financial institutions that make it difficult for banks to also help smaller customers.

Stern, who is retiring from his post with the Minneapolis Fed this summer, said that the severity and breath of the recession - the impact has not been limited to only one or a few areas of the economy - what will boost the economy out of recession is hard to identify.

Despite the risks to his outlook, Stern stood by his prediction of a resumption of healthy growth by the middle of 2010.

He also attempted to ease fears regarding inflation, and the inflationary risks associated with the booming Fed balance sheets. However, there is ample time fir the Fed to withdraw excess liquidity, he said, although policymakers will have to be acutely sensitive to acting as soon as appropriate.

Stern also revisited the issue of a Federal Reserve role in the identification and deflation of asset price excesses, or bubbles, such as the housing bubble earlier this decade. The collapse of the housing bubble has dragged on the economy and is cited as the source of much of the current financial turmoil. The wisdom of governments intervening to stop asset bubbles in order to prevent catastrophic collapses has been debated by economists for decades. However, the Federal Reserve has taken a hands-off approach, an approach Stern suggested should be re-examined.

Stern admitted it is difficult to identify these excesses before they get out of hand. In addition, once identified it can be difficult build public support to stop the build-up, and after all that there is the challenge of weighing the costs and benefits of action for the broad economy.

Nevertheless, in view of the damage resulting from the decline in housing values, as well as the aftermath of the collapse of prices of technology stocks earlier this decade, I think it essential to revisit these issues, the Minneapolis Fed President said.

Identifying such excesses would be challenging but does not appear to be beyond the realm of possibility, Stern said. Citing work in academic circles, the Minneapolis Fed President noted that while asset bubbles could be wrongly identified, that risk could be mitigated by a measured policy response resulting in modest ramifications for the economy.

Although Stern did not cite any specific work, many studies has been done on the subject of deflating asset bubbles, including by former students of Federal Reserve Chairman Ben Bernanke at Princeton.

Stern, the longest-serving Federal Reserve Bank president at 23 years in the position, will officially retire in the summer.

Stern, 64, assumed the position as Minneapolis Bank president in 1985. In recent years he has been outspoken on the too-big-to-fail problem so evident in the current financial crisis. In his statement leaving the bank, Stern called the current financial crisis the most difficult he's faced in his career with the bank.

However, he added that he is confident that with Bernanke's leadership, the financial system will fully stabilize and economic growth will return.

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