By Jonathan SpicerBOSTON (Reuters) - The question of whether the Federal Reserve should adjust interest rates to deflate risky financial market bubbles split some top Fed policymakers on Friday, suggesting the controversial idea is re-emerging as the U.S. central bank approaches an historic policy tightening.Giving the central bank an effective third mandate - beyond its formal objectives for inflation and employment - has won more adherents since the 2007-2009 financial crisis, which some blame in part on too-easy monetary policy in the preceding years that allowed risks to take root.As the Fed approaches its first rate hike in nearly a decade, one reason to act sooner than later is to head off any brewing instabilities in risky corners of financial markets such as leveraged loans, high-yield debt and even automobile lending.So far the Fed's approach has been to use financial regulations and supervision of banks and other firms - so-called macroprudential tools - to head off any emerging risks. Monetary policy has focused on achieving the goals of 2-percent inflation and maximum stable employment.But Fed officials discuss financial stability quite frequently in their meetings and those discussions already do influence policy decisions, according to a paper co-authored by Boston Fed President Eric Rosengren."There are reasons to believe that financial stability should be an explicit consideration of monetary policymakers," concluded the paper, published Friday at a Boston Fed conference attended by central bankers from around the world.Rosengren, among the dovish Fed officials who prefers to keep rates low to boost employment, called the research "an initial foray into this area ... but it does capture I think the way we seem to behave."The paper was based on the number of times Fed officials mentioned terms related to financial stability in policy meetings from 1987 through 2009, which is the latest year for which transcripts are available.References spiked in the late-1990s technology bubble and again in the recent crisis, it found, with for example "stock market" referenced 1,210 times in that time frame, "bust" 982 times, "volatility" 853 times, and "froth" 30 times.Concerns about possible bubbles in the financial system have increasingly come to the foreground as policymakers consider when to begin raising rates after nearly seven years near zero, with Fed Chair Janet Yellen and most others predicting the move will happen later this year.Yellen and others have publicly worried that keeping borrowing costs too low for too long can fuel too much risk-taking by investors and possibly destabilize the economy.However Narayana Kocherlakota, another dove and the head of the Minneapolis Fed, came out strongly against adding the goal of stabilizing the financial system to the U.S. central bank's list of duties, saying that doing so would add to existing public uncertainty over the Fed's existing two goals."Adding a financial stability mandate would likely generate more public uncertainty about policy choices and economic outcomes," Kocherlakota told the conference in response to the paper.The Fed should only be concerned about financial stability to the extent that it affects its ability to reach its other two goals, which are enshrined in U.S. law.The Fed should be clearer about its existing goals, and should promise to calibrate policy so that it can reach its inflation goal within two years, he said, adding it would need to ease - not tighten - policy to reach such a deadline.Cleveland Fed President Loretta Mester, also in Boston, cautioned that monetary and macroprudential policy discussions should probably be separated to protect the central bank's cherished independence."If effective monetary policy means taking away the punch bowl just as the party gets going, then effective financial stability policy might mean taking away the punch bowl before the guests have even arrived because the risks to financial stability build up over time and action likely needs to be taken earlier in order to be effective," she said.While the Fed is bound by the 2010 Dodd-Frank financial reform law to defend against risks to the financial system as a whole, it has generally interpreted that to mean directly supervising banks and other financial institutions, and writing tougher rules on things like capital standards.Randall Kroszner, who was a Fed governor during the crisis, said the central bank is still struggling to figure out its new role of ensuring financial stability."We don't want to have central banks to prevent risk-taking from occurring," he said. "It's a much trickier issue."(Reporting by Jonathan Spicer; Additional reporting and writing by Ann Saphir; Editing by Chizu Nomiyama)Join the conversation about this story
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