Dudley: Fed should act to contain asset bubbles

The head of the New York Fed urged central bankers Wednesday to learn from the financial crisis and be more proactive in combating speculative bubbles in assets such as stocks or real estate.

"We need to re-examine how central banks should respond to potential asset bubbles," William Dudley, president of the Federal Reserve Bank of New York, said in a speech Wednesday. "The costs of waiting to respond to an asset bubble until after it has burst can be very high."

The Federal Reserve, especially under Alan Greenspan's leadership from 1987 until 2006, took a hands-off approach. It did not typically act to prevent speculative bubbles, arguing that it was difficult to gauge when a bubble was developing. Instead, it would act to stabilize the financial system only after a bubble would burst.

Greenspan has been criticized for failing to counteract the surge in housing prices. The collapse of the housing market sparked the credit freeze and recession.

Dudley, who is a member of the Fed's committee that sets interest rates, said the difficulty of determining whether a price rise was a "bubble" could not be an excuse for inaction.

Dudley, a former Goldman Sachs chief U.S. economist, said the most effective way for the central bank to move against asset bubbles was not through the broad tool of hiking or cutting interest rates. He advocated regulatory measures, such as changing capital requirements for financial institutions and limiting overall leverage, or using the "bully pulpit" of the Fed to caution markets about a rapid increase in asset prices.

The Obama administration and Fed Chairman Ben Bernanke have pushed for a broader supervisory role for the Fed in regulating the financial system.

Dudley said that giving regulators a "sufficient tool kit" to combat asset bubbles was a good idea. But he cautioned that "lodging all this authority within a single entity or institution might not be practical or desirable."