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Morgan Stanley’s Roach Sees Risk in Fed Exit Strategy (Update2)
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By Simon Kennedy and Michel Doermer

Dec. 12 (Bloomberg) -- The Federal Reserve may cause another crisis by botching the withdrawal of liquidity from the U.S. economy, Morgan Stanley Asia Chairman Stephen Roach said.

The Fed is the “weak link” among central banks and may fail to tighten monetary policy in time to stop asset bubbles from forming, Roach said at a conference in Berlin today. The Fed helped trigger the boom and then bust of the subprime mortgage market by being “quick to slash, slow to normalize” interest rates, he said.

Fed Chairman Ben S. Bernanke said Dec. 3 he doesn’t rule out using monetary policy to prevent unfounded increases in asset prices, though he said financial regulation is a better approach. Bernanke said this week the U.S. economy continues to face “formidable headwinds,” signaling the Fed will keep its benchmark interest rate near zero for an extended period.

“They need to be very early in executing their exit strategies,” Roach, a former Fed economist, told Bloomberg Television. “I take Mr. Bernanke at his word that he’s looking for an extended period of monetary accommodation, which, quite frankly, I find very worrisome in assessing the prospects of a next bubble and the next crisis.”

‘Ludicrous’ View

The traditional view of central bankers that asset bubbles are hard to spot and deflate with rates is “ludicrous,” he said.

“This is a failed flaw in the intellectual construction of modern central banking that must be addressed,” said Roach. “If we don’t fix this problem we’re doomed to repeat the failed asymmetric policies of the past and set ourselves up” for another crisis.

Roach recommended the Fed be required to “hardwire” the goal of preserving financial stability into its mandate, alongside the pursuit of full employment and low inflation. Central banks should not be “allowed to outsource their responsibilities” to regulatory bodies, he said.

Nobel laureate Robert Mundell told the conference that the Fed mismanaged monetary policy by not raising interest rates fast enough in the last recovery when gold and commodity prices rose.

It was an “insane, stupid policy,” he said. “Where’s the mea culpa from the Fed?”

Asset Bubbles?

While no Fed official spoke at the Berlin event, European Central Bank Vice President Lucas Papademos told reporters that in the future “there may be scope for the use of monetary policy as an instrument to also contribute to financial stability” in harness with other tools such as supervision.

Asked if he was concerned that asset bubbles are now forming, Papademos said he “wouldn’t come to this conclusion” because even with recoveries in markets and at banks, the financial system “is still facing challenges.”

“Overall financial conditions have not reached a stage that are signaling risks to financial stability,” he said.

Papademos defended central banks as having “avoided the meltdown of the financial system and through a variety of measures we are contributing to the return of the financial system to conditions of normality.”

Bernanke said on Dec. 3 that “regulation of the financial system is the strongest, most effective” way to deal with bubbles. “I do not rule out using monetary policy if necessary, if that situation does become worrisome and threatening,” though there are no signs of “extreme misvaluations,” Bernanke told the Senate Banking Committee.

To contact the reporters on this story: Simon Kennedy in Paris at [e-mail]
Last Updated: December 12, 2009 11:21 EST