WASHINGTON, March 6 (Reuters) - Policy-makers cannot neglect asset price and credit booms and may need to step in when leveraged financing inflates bubbles, the International Monetary Fund said on Friday.
The IMF said monetary policy should address the stability of the broader financial system, not just prices. While inflation remains the primary focus, they said central banks "must take more account of asset price movements, credit booms, leverage and the build-up of systemic risk."
Some central banks -- notably the U.S. Federal Reserve -- argue that it is hard to spot bubbles as they form, and the best approach is to let them pop on their own and then step in with interest rate cuts or other measures to safeguard the economy from the fallout.
The severity of the current crisis has prompted many questions about whether policy-makers ought to intervene sooner to ensure that huge asset bubbles cannot wreak havoc on the financial system.
"To the extent that the build up of systemic risk can portend a sharp economic downturn, and to the extent that regulation cannot fully prevent such a buildup, it is now clear that policy-makers cannot neglect asset-price and credit booms," the IMF wrote in a paper released on Friday.
The paper was part of a series detailing the IMF's policy advice before a meeting next week of finance leaders from the Group of 20 rich and developing nations.
While the IMF acknowledged that speculative booms were hard to identify, they said it may be better to take preemptive action when policy-makers think there is a strong likelihood of a bubble, much the same as they would raise interest rates in the face of rising inflation risks.
"In addition, special attention should be paid to real estate booms since they typically involve a high degree of borrower leverage," the IMF said.
However, they said monetary policy has its limitations, so regulation would need to play a major role.
"For instance, minimum regulatory capital requirements should be increased during upswings and lowered in downturns and more aggressive provisioning should be encouraged during periods of fast credit growth," they said.
"Such policies should go beyond the current focus on the risks to individual banks and be based on system-wide measures."
The Fund also said many countries did not reduce budget deficits enough during boom years when revenues were high, leaving them with less fiscal space to combat the crisis, and tax systems that let borrowers deduct interest payments encouraged an unhealthy build-up of debt.
"This bias to higher leverage increases the vulnerability of the private sector to shocks, and should be eliminated," the IMF said. (Reporting by Emily Kaiser; Editing by Tom Hals)