Banks ignored crisis warnings, IMF says

WASHINGTON — The Federal Reserve and other central banks made a mistake by ignoring warning signs of an asset bubble brewing in residential real estate and complex securities markets earlier in this decade, the International Monetary Fund said last week.

While loose monetary policy was not the "smoking gun" that single-handedly caused the current crisis, central banks should have heeded early warnings signs and headed off the disaster before it took down the global economy, the IMF said as it released several chapters of its semiannual World Economic Outlook.

The full report, including an updated world economic forecast, will be released Thursday.

"Monetary policymakers could usefully place greateremphasis on avoiding asset prices busts," said economists at the fund. "There were warning signs ahead of the current crisis that monetary policymakers could have heeded."

Although the Fed and the other central banks made policy mistakes as the bubble inflated, they've done the right thing during the bust by pouring stimulus into the economy, according to the results of another study published in the outlook.

Looking at 88 banking crises over the past 40 years, the IMF found that the drop in economic output over the medium term was lessened by "forceful macroeconomic policy response," such as lowering interest rates, lending freely, adopting fiscal stimulus spending plans, and forcing structural reforms.

The study has "sobering implications" for the global economy, the IMF said. Forthe average country suffering a banking crisis, output is typically 10 percent below trend seven years later.

Implementing structural reforms is necessary to limit the damage, the IMF said. Bubbles have the effect of misallocating capital and labor, and such imbalances can persist for years unless authorities insist on sometimes-painful structural changes.

In looking at past crises, the IMF said a collapse in asset prices, such as the global bust over the past two years, was "often foreshadowed by rapidly expanding credit, deteriorating current account balances, and large shifts into residential investment.

"With inflation typically under control, central banks effectively accommodated these growing imbalances, raising the risk of damaging busts."

Once the Fed identified an asset bubble, it could havetightened monetary policy and raised U.S. interest rates "earlier and more vigorously to try to prevent dangerous excesses from building up, even if inflation appears to be under control," the IMF said.

Preventing bubbles and busts would be a new - and difficult - mandate for the Fed and other central banks. In the past, they've argued that policy should focus on maintaining stability in consumer prices, not on trying to guess whether movements in asset prices are the result of reasonable or unreasonable expectations.

Both Fed chief Ben Bernanke and predecessor Alan Greenspan have said that the U.S. central bank cannot identify bubbles but that it should be prepared to "mop up" after they burst.

The Fed has never tightened policy in response to higher asset prices, but it has nearly always loosened policyin any major sell-off. That has effectively guaranteed that investors will be rewarded during bubbles but not punished equally during busts.

Instead, the IMF said, central banks ought to lean the other way.

The IMF suggested that the Fed and other big central banks could adopt "macroprudential" policies to damp credit-market cycles, such as requiring banks to set aside more capital as leverage rises.

Still, managing asset prices will be tricky, the IMF acknowledged, because it's not always clear ahead of time "whether booms are driven by benign or malign circumstances."

In light of the inevitable political considerations, popping an asset bubble before it gets too big could be effectively impossible for any but the most independent and thick-skinned central banker.