Monetary and regulatory policies can fuel asset bubbles that can then pop, leaving economic wreckage in their wake, a top Federal Reserve official warned on Monday.

Contrary to accepted theory, asset-price crashes like the house-price collapse that set off the Great Recession are not a product of some external shock, but are inherent in the way financial markets work, San Francisco Fed President John Williams said in remarks prepared for delivery to the National Association for Business Economics.

Policymakers must retool their approaches to take such a possibility into account, he said.

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"To understand the past and avoid a recurrence of the devastating events we lived through so recently, we need to acknowledge that investors and financial markets do not behave the way rational asset price theory implies," Williams said.

"This opens up a world where actions, including regulatory and monetary policy measures, may have unintended consequences — such as excessive optimism, risk taking, and the formation of bubbles — that are assumed away in standard rational models."

One important implication of this view, Williams said, is that monetary policies can have longer-lasting effects than usually recognized.

"In particular, the policy response to cyclical movements in economic activity and inflation may have effects on investor beliefs and the behavior of asset prices that reach well into the future," he said.

Williams did not tell the audience of Wall Street and academic economists precisely how his thinking on asset bubbles might impact his view on current monetary policy.

But his focus on asset bubbles and crashes in a speech just one week ahead of a key Fed policy-setting meeting suggests at the very least that he is thinking hard about the potential unintended consequences of the Fed's super-easy monetary policy.

Though not a voting member of the Fed's policy panel this year, Williams will take part in discussions next week that many economists expect will result in the Fed beginning to trim its massive bond-buying stimulus. The U.S. central bank is currently buying $85 billion in long-term securities each month to reduce borrowing costs and boost investing and hiring.

Fed officials, including Williams, have suggested that reducing the Fed's pace of bond-buying is justified because the labor market is healing. But some Fed officials also have said they worry that current policies could fuel future bubbles.

Last week Williams, speaking in Portland Ore., said he believed that the surge in bond yields in May after Fed Chairman Ben Bernanke suggested the Fed could cut back on its bond-buying stimulus in coming months suggested there had been "froth" in the bond markets that he had not anticipated.

"The lesson from history is clear: asset price bubbles and crashes are here to stay," Williams said. "They appear to be a consequence of human nature."

"For monetary policy, one implication of theories with endogenous asset price bubbles is that the time horizon over which policy affects the economy may be longer than typically thought," Williams said.

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