ATLANTA — The Federal Reserve must be open to raising interest rates to pop future asset bubbles, even though stronger regulation remains the best solution to prevent a repeat of the crisis, the Fed chief said Sunday.
Fed Chairman Ben Bernanke said all efforts should be made to strengthen the U.S. regulatory system to prevent a repeat of a financial crisis that Bernanke described as possibly the worst in modern history.
"However, if adequate reforms are not made, or if they are made but prove insufficient to prevent dangerous build-ups of financial risks, we must remain open to using monetary policy as a supplementary tool," Bernanke told an annual meeting of the American Economic Association.
Critics have said the Fed kept interest rates too low for too long in early 2000, helping to fuel a housing bubble at the root of the recent financial crisis. The same critics now see a risk that, with the Fed's key short-term rate at a record low close to zero since Dec. 2008, a new bubble may already be forming.
Although admitting that monetary policy was accommodative in early 2000, Bernanke said lax supervision of toxic mortgages by the Fed and other bank regulators, as well as excessive flows of capital around the globe, were the main reason behind the housing bubble.
Dale Jorgenson, a Harvard professor who served as Mr Bernanke's thesis adviser at MIT in the 1970s, said the Fed chairman made a "pretty convincing" argument that low rates were not the driving force of the housing bubble.
But he said Bernanke should have laid more blame at the feet of Congress for encouraging reckless mortgage lending with its support of Fannie Mae and Freddie Mac and other policies meant to increase home ownership.
"I didn't hear any word with regard to going back to Congress about changing housing policy," he said.
Although Bernanke is expected to be reconfirmed as Fed chief by Congress, he faced strong opposition from some Senators in the nomination hearing last month. The central bank's powers could be severely cut if some bills become law.
Until now, the Fed's main strategy has been to mop up after a bubble burst with lower interest rates to cushion the blow to the economy, instead of trying to prick a bubble pre-emptively by raising rates.
Such a strategy was a key conclusion of Bernanke's writings on the subject of bubbles when he was an economics professor, and again when he first came to the Fed as a governor in 2002.
"Clearly, we still have much to learn about how best to make monetary policy and to meet threats to financial stability in this new era," Bernanke told "Maintaining flexibility and an open mind will be essential for successful policy-making as we feel our way forward."
Turning to the Fed's future moves to withdraw the extraordinary stimulus it made to counter the crisis, Bernanke said the U.S. central bank had a "robust" strategy in place.
The Fed chief said the strategy "includes both raising the interest rate that we pay on reserves, plus a number of measures that we have been testing that will allow us to drain reserves from the system".
The central bank last week proposed selling interest-bearing term deposits to banks, a move that would help drain the extraordinary amount of money pumped into the economy once the central bank decides to tighten policy.
The Fed is also testing another tool, reverse repurchase agreements, in which the central bank sells securities from its portfolio with an agreement to buy them back later. Under the arrangement, the buyers move cash from banks to the Fed, removing reserves from the system.
Earlier Sunday, Fed Vice Chairman Donald Kohn said the central bank will need to be ahead of the curve in withdrawing stimulus as the economy gradually improves.
Kohn also flagged the Fed's ability to pay interest rates on bank reserves, along with temporary actions the Fed can use to move securities off its balance sheet as key tools.