By Ann Saphir and Richard Valdmanis
CHICAGO/BOSTON (Reuters) - The Federal Reserve should be "extraordinarily careful" about hiking interest rates to head off potential risks to financial stability, a top U.S. central banker said on Friday, warning about consequences to the economy.
Another policymaker underscored the importance of the issue of asset bubbles as he laid out possible approaches to protecting the broader economy, but without endorsing any one.
The debate over whether tighter policies should be used to battle asset-price bubbles has simmered under the surface as the Fed has taken unprecedented steps to boost economic growth, including trillions of dollars in bond-buying and promises to keep interest rates low for long periods.
Since the implosion of the U.S. housing bubble touched off the financial crisis that reverberated around the world, the role of asset bubbles has become a regular source of scrutiny and debate.
Monetary policy is traditionally used only to target inflation rates, and in the United States to also encourage maximum sustainable employment.
Chicago Fed President Charles Evans said raising rates to tamp down risk-taking, when what the economy needs is support from low rates, is a "poor choice." He said there are more effective tools, such as supervision, and said they are better choices.
"If more restrictive monetary policies were pursued to generate higher interest rates, they would likely result in higher unemployment and a sharp decline in asset prices, choking the moderate recovery," Evans, a dovish Fed policymaker, told the Financial Management Association's annual meeting in Chicago.
"Such an adverse economic outcome is unlikely to set a favorable foundation for financial stability."
In Boston, Jeremy Stein -- the Fed governor who in February gave a speech that set off an ongoing debate over battling bubbles with tighter policies -- on Friday only laid out three "schools of thought" on the issue but did not specifically back any of them.
The three approaches he listed were: use policy to tackle financial imbalances; rely on supervision and regulation; be "generally suspicious" of using policy or regulation to avoid bubbles, an approach that "emphasizes the difficulty of identifying emerging financial imbalances in real time."
"The debate between these three schools gets a lot of attention at venues like this one -- and with good reason," Stein said at a National Bureau of Economic Research conference.
"It touches on issues that are not only of policy interest, but also connect to deeper and strongly held views about how the world works."
In an effort to pull the U.S. economy out its worst downturn in decades, the Fed has kept short-term interest rates near zero since December 2008 and is buying $85 billion in Treasuries and housing-backed securities each month to lower long-term borrowing costs as well.
Central bank officials have promised to keep rates near zero until unemployment falls to at least 6.5 percent, as long as inflation expectations remain below 2.5 percent.
The low rates are aimed at encouraging investment and hiring, and Evans and Stein, two of ten current voters on Fed policy this year, have supported the policies.
John Williams, president of the San Francisco Fed, who participated in the panel in Boston with Stein, predicted there will be no need for the bond-buying, nor for tying interest-rate changes to specific economic "thresholds," once the central bank finally raises rates and things return to normal.
A "BLUNT" TOOL
Some Fed officials are worried about whether easy policies are fueling unseen asset bubbles, and have cited financial stability concerns as one reason the Fed should pare its bond-buying program.
Esther George, president of the Kansas City Fed, who has dissented at every Fed policy-setting meeting this year, has warned that keeping rates too low for too long could fuel excessive risk-taking. Richard Fisher of the Dallas Fed, an equally hawkish policy maker, on Thursday said he was increasingly concerned that low rates were contributing to a nascent housing bubble.
Evans acknowledged that part of the goal of the Fed's easy-money policies is indeed to encourage risk-taking, because in times of a weak economy people and businesses often go into a defensive crouch.
While Evans did say that leaving rates too low for too long can lead to excessive risk-taking among some investors, he said that raising rates prematurely is likely to do more damage than good to the economy as a whole.
"We ought to be extraordinarily careful if we are going to use our blunt short-term interest rate tools, figuratively speaking, in order to address that," he told reporters after the speech.
While excesses in the mortgage market were at the core of the financial crisis, Chairman Ben Bernanke and most other Fed officials have downplayed worries over dangerous bubbles emerging today. Further, they have pointed to tougher rules on banks as a safeguard.
In Washington, the president of the New York Fed, William Dudley, said regulators need to find ways to force financial firms to take actions that would keep them from running into the type of trouble that could call for unwinding the firms.
"We need to do more to create incentives to force banks to act sooner to steer away from impending icebergs," Dudley told a regulation conference.
Fed Governor Daniel Tarullo, at the same event, said the biggest unfinished job for supervisors globally is reforming short-term funding markets in which banks finance large parts of their business.
(Additional reporting by Douwe Miedema and Jason Lange in Washington and Jonathan Spicer in New York; Writing by Jonathan Spicer; Editing by Leslie Adler)