In what could be seen as a veiled swipe at the Federal Reserves extended period language, European Central Bank executive board member Lorenzo Bini Smaghi warned that if rates stay low for too long, they could fuel another asset bubble.
Any commitment to prolonged periods of low interest rates is risky, Bini Smaghi said in a speech posted on the ECBs Web site Tuesday. If the aim is to lower long-term rates, it may also encourage market participants to take substantial long positions in the fixed income market, he said, and risk suffering heavy losses when policymakers exit from their accommodative policies.
The risk of such losses may induce the central bank to further delay the exit to avoid penalizing banks, Bini Smaghi said, which seems to be the experience of 2002-2004.
As a result, interest rates may remain below the desired level for too long, fueling a possible bubble, he said.
That appears to contradict Ben Bernankes recent assertion that low interest rates during that time didnt fuel the U.S. housing bubble.
Bini Smaghis comments were posted on the first day of a two-day meeting of the Federal Reserve, where officials are expected to maintain their longstanding commitment to keep rates exceptionally low for an extended period.
The ECB officials worry? That policymakers — he didnt cite any central bank in particular — will send a signal that theyre less worried about exiting too late then they are exiting too early. If thats the case, market participants could expect low rates to be extended beyond what is necessary, Bini Smaghi said.
He even disputed the textbook example of exiting too early: the US experience in 1936, largely seen as a mistake not to be repeated since it preceded the 1937-38 recession. In fact, examining closely the 1936 episode in the U.S., it might not even be considered as an early exit, Bini Smaghi said.
The 1936 episode might be considered as an example of a badly calibrated and badly communicated exit, rather than a wrongly timed exit.