By Brai Odion-Esene and Stephen Sandelius

PARIS (MNI) - Chicago Federal Reserve President Charles Evans Friday called for a shift in Fed policy to combating "apparent exuberance" in asset markets and the risk it could pose, rather than acting based on the belief that certain assets are overvalued.

In remarks prepared for a conference in Paris organized by the Banque de France, Evans argued that, "As long as we can't detect bubbles with great confidence, it seems unwise to adopt fighting them as a policy objective, even if only sparingly."

Instead, he continued, "it seems better to commit to what central banks are already mandated to do: preserve the safety and soundness of the financial system at all times, including when there is apparent exuberance in asset markets."

Evans came out strongly in favor of a proactive response by a central bank, as opposed to "simply waiting and mopping up after the fact if and when the prices of some assets do collapse."

However, rather than acting to lower asset prices that seem unusually high, "I prefer to see policy reacting to apparent exuberance in asset markets and the problematic risk exposure this could create, rather than initiating action out of a strong conviction that these particular assets are overvalued," he said.

Evans added, "I view the goal of intervention as insuring that exuberance in asset markets does not ultimately threaten the financial system or contribute to financial distress."

Noting the change in the wake of the financial crisis of the conventional view on how policy should respond to bubbles, he cited two arguments why central banks should not respond to bubbles.

First of all, he said, it is virtually impossible to determine whether an asset is trading above its fundamental value, certainly not in real time and often not even after the fact. Secondly, monetary policy as a tool is too blunt to prick bubbles effectively, he continued, because it cannot be targeted precisely, and will affect other financial and macroeconomic variables beyond just the set of asset prices in question.

He argued that the crisis has not done enough to warrant changing this viewpoint, voicing his skepticism about a central bank's ability to "easily and definitively sort out in real time whether a rapid increase in asset prices is associated with overvaluation."

"Each new episode is likely to involve its own idiosyncratic features -- enough to bring a new chorus proclaiming that 'this time [it] is different' and arguing that we are not in fact facing a bubble," he said.

As for the bluntness of monetary policy tools, "I don't think the crisis has demonstrated that the typical levers of monetary policy are any less blunt than we used to think," Evans said.

Looking ahead, Evans counseled that if the ultimate goal is to reduce the likelihood of future crises, "our policy response should focus on achieving financial stability rather than on identifying and purging asset bubbles per se."

He added, "An appropriate policy response may entail responding to bubbles, but I would argue that this should only be a means to achieving the broader goal of financial stability, rather than an end in and of itself."

Regulatory policy provides the most promise in this regard, Evans said, adding his voice to calls for an improvement in resolution procedures for financial institutions. Not only would that reduce threats to the broader system, he said, but also improve communication between regulators and institutions that facilitates horizontal reviews. In so doing that would help first identify and then reduce potential systemic risk exposures.

At the same time, Evans went on to say, maintaining financial stability is also likely to involve "more-proactive, state-contingent measures, that is, policies that vary with economic conditions." For example, he said, when faced by several indications that asset markets may be exuberant, capital requirements could be increased either for all or specific financial institutions that choose to hold assets for which there is concern of a price collapse.

"These requirements should serve as a cushion if purchases of these assets result in losses," he said, and could end up putting downward pressure on asset prices and, at some point, even eliminate speculative excesses.

Evans took pains to stress yet again that lowering asset prices would not be the direct intent of these policies and, therefore, not the way their success would be judged.

"We should consider an intervention successful if it helps to safeguard financial institutions and the real economy in the event that asset prices collapse, not if it manages to lower asset prices to better reflect the true worth of the underlying assets," he said.

Evans argued that an advantage of using financial stability as the metric is that it does not require a central bank to take a stand on whether the assets in question are overvalued.

Rather, the responses would be implemented whenever there are concerns that asset prices may experience a sharp decline in the future, he said, regardless of whether this decline is driven by fundamentals or by the bursting of an asset bubble.

In closing, Evans said the proposals he has outlined are "not out of scope" of the thinking of other policymakers who often give regulatory policy a prominent role.

"Thus, while I might motivate and describe the appropriate policy response somewhat differently, my recommendation does not represent a radical departure from what others have argued," he concluded.

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