In Philadelphia on Thursday, Fed Governor Frederic Mishkin said central banks can do more harm than good when they try to use interest rates to pop the type of asset price bubbles that led to the current crisis.

“Not all asset price bubbles are alike,” he said.

But he added that financial regulators may be able to prevent the market failures that often inflate such bubbles. That is especially true in credit-driven booms, as loose lending pushes prices higher, creating create a “negative feedback loop,” he said.

With monetary policy focused on ensuring price stability and sustainable employment, “it falls to regulatory policies and supervisory practices to help strengthen the financial system and reduce its vulnerability to both booms and busts in asset prices,” he said.

The New York Fed’s Dudley, the central bank’s money market operations guru, spoke about the credit crisis for the first time since October, in comments titled, “May You Live in Interesting Times: The Sequel.”

Contrary to a recent study by two leading economists, Dudley said the evidence suggests that the Fed’s lineup of new emergency lending facilities has improved financial market functions in recent months.

Still, problems in the banking sector — especially deleveraging, or the shedding of assets now viewed as too risky or illiquid by financial institutions — will not be easily worked through, Dudley said.

“It will take time for market function to return to normal. The reintermediation and deleveraging process has, in my view, a considerable ways to go,” he said.

The Fed’s willingness to provide liquidity against less liquid collateral has smoothed out and extended, but not prevented, the credit market’s shakeout, he said.

This less jagged process “causes less damage to the financial system and less pernicious macroeconomic consequences,” Dudley added.

Smoother or not, the credit crisis that was brewing in early 2007, and hit with hurricane force last August, has pushed the United States economy to the brink of recession.

Dudley said that the recent widening in certain interest rate spreads suggested “increased balance sheet pressure on banks.” If so, the Fed can only do so much to help.

“There are limits to what the Federal Reserve can accomplish in terms of narrowing such funding spreads. After all, the Fed’s actions cannot create bank capital or ease balance sheet constraints materially,” he said.

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