RTTNews - San Francisco Federal Reserve Bank President Janet Yellen said Friday that the Federal Reserve should use monetary policy to deflate asset bubbles. Speaking as part of a panel at the Federal Reserve's conference on Financial Markets and Monetary Policy in Washington D.C., Yellen discussed how the financial crisis has forced the Fed to reassess its approach to the issue and suggested that reigning in bubbles could lead to increased financial stability.

In the current episode, higher short-term interest rates probably would have restrained the demand for housing by raising mortgage interest rates, and this might have slowed the pace of house price increases, Yellen said in prepared remarks.

Thus, monetary policy that leans against bubble expansion may also enhance financial stability by slowing credit booms and lowering overall leverage, she added.

Yellen is not the only Fed official to discuss 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.

In a speech last month, Minneapolis Fed President Gary Stern admitted that 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 he said there is the challenge of weighing the costs and benefits of action for the broad economy.

Identifying such excesses would be challenging but does not appear to be beyond the realm of possibility, Stern said.

Yellen noted these risks, or pitfalls, in trying to deflate the bubbles. Specifically, damaging the economy unnecessarily if something is inaccurately identified as a bubble.

I would not advocate making it a regular practice to lean against asset price bubbles, Yellen said. But, in my view, recent painful experience strengthens the case for using such policies, especially when a credit boom is the driving factor.

Yellen also addressed the long-run inflation objective, or the rate that best promotes the Federal Reserve's dual goals of maximum sustainable employment and price stability. While in the past Yellen has favored a 11/2 percent rate of PCE price inflation, she noted that the recession and financial crisis have caused her to re-examine her view.

Some research suggests that while economic output might be hurt by an inflation objective of 1 percent or lower, the impact on average macroeconomic performance at higher inflation objectives is minimal. However, Yellen noted that there have been two deflation scares and a severe global recess in the past seven years and suggested that with all other countries are in recession and cutting rates, it is harder to stabilize the economy and avoid deflation.

She also called the recent rise in Treasury rates disconcerning in light of the Fed's purchase of longer-term treasury securities.

For example, some observers worry that the ballooning of the Fed's balance sheet may raise inflation because the Fed may face political and technical challenges when it tries to unwind these policies-especially if the recession ends before the need for support of the financial markets fades, Yellen warned. While I have not found these arguments convincing so far, the recent rise in Treasury rates, if it is reflective of such concerns, is disconcerting.

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