FRANKFURT, Nov 19 (Reuters) - Financial markets may be exaggerating growth prospects and fuelling price bubbles, creating a dilemma about how long to keep interest rates low, European Central Bank Executive Board member Lorenzo Bini Smaghi said on Thursday.
In a speech to be delivered in London, Bini Smaghi rejected arguments that it is better for central banks to withdraw their support for the economy too late rather than too early.
He also urged national authorities to address over-reliance on cheap, unlimited ECB funds by some banks -- a step already taken by the Greek central bank, which has advised banks to show restraint in borrowing 12-month ECB funds. [ID:nLG450007]
"Banks have to start thinking about standing on their own feet as soon as they can, and about resorting to the traditional sources of funding," he said in a text prepared for delivery.
Economists do not expect the ECB to raise rates from their current record low of 1 percent until the third quarter of 2010, but Bini Smaghi's comments reflect growing concern at the euro zone central bank about the dangers of a loose policy stance.
The ECB has already said it will start unwinding some of its extra liquidity steps next year, a process Bini Smaghi confirmed would be timely but gradual.
Current low rates were consistent with the ECB's analysis signalling no pressure on inflation, but abundant central bank liquidity -- if not passed on by banks as loans -- could lead to short-term market upheavals, potentially restraining growth.
"The question is, how long can low levels of interest rates be maintained without creating distortions in the efficient allocation of funds by the financial sector, and possibly endangering price stability?" he said.
Bini Smaghi pointed to a growing gap between the situation in financial markets, where stock markets had risen 50 percent since march and bond market spreads had declined, and the real economy, where the growth outlook was improving but uncertainty remained.
"Overall, the assessment underlying financial market conditions appears somewhat more optimistic than the consensus forecast for economic recovery," he said, noting that low rates and a return of risk appetite might spark speculation.
"Monetary policy might thus be insufficiently effective in stimulating economic recovery, but too effective with respect to risks of asset price bubbles in the financial sector."
TOO EARLY VS TOO LATE
Bini Smaghi said observers offer underestimated the damage to an economy from leaving stimulus measures in place too long -- backing comments by fellow policymaker Axel Weber, who has also warned against missing the right time for an exit.
"I would prefer not to listen to those who are recommending a bias in deciding the timing of the exit i.e. that it's preferable to err on the side of late rather than early withdrawal," he said.
The Organisation for Economic Co-operation and Development said on Thursday the ECB should keep rates low until late 2010. [ID:nLI592160]
Bini Smaghi said one-year government bond yields were
currently below one-year inflation expectations
Keeping official rates unchanged while expectations for growth and inflation over the coming two years were systematically revised up suggested that the policy stance was actually becoming looser.
The outlook for the economy had improved significantly in the last six months, he said, adding that he did not want to pre-empt ECB staff forecasts due in December.
The euro area grew 0.4 percent in the third quarter and "available evidence indicates that the situation has continued to improve in the fourth quarter".
But there were risks, he said, pointing to further rises in commodity prices, pressure on the banking sector and its ability to provide credit to firms and households.
"Another risk is the potential instability in financial markets, in particular with respect to excess volatility in the foreign exchange markets, which is detrimental to export and investment decisions," he said. (Reporting by Krista Hughes; Editing by Ron Askew)