May 13 (Bloomberg) -- The Federal Reserve may soon need to raise interest rates, said John Taylor, the former Treasury official who devised the “Taylor Rule,” a formula for rate- setting based on the outlook for inflation and growth.

“My calculation implies we may not have as much time before the Fed has to remove excess reserves and raise the rate,” Taylor, a Treasury undersecretary under President George W. Bush from 2001 to 2005, said yesterday at an Atlanta Fed conference in Jekyll Island, Georgia.

Fed Chairman Ben S. Bernanke said earlier this week at the conference the Fed was prepared to withdraw monetary stimulus “in a timely way” to prevent inflation from becoming a threat when the economy recovers. Former Federal Reserve Chairman Alan Greenspan said yesterday that the decline in the U.S. housing market may be bottoming and it’s “very easy to see” financial markets continuing to improve.

Taylor, a Stanford University professor, disagreed with economists who say his rule suggests the need for stimulus and justifies cuts in the federal funds rate to negative territory. Laurence Meyer, vice chairman of Macroeconomic Advisers, said in March the rule might suggest the need to reduce the funds rate to minus 7.5 percent by the end of 2009.

Taylor said his rule, based on inflation and economic growth compared with the long-term potential for growth, suggests a fed funds rate of 0.5 percent. The central bank has cut rates to between zero percent and 0.25 percent.

Fed’s Fault

The Fed helped to trigger the current financial crisis by keeping rates too low for too long, Taylor said.

“Low interest rates led to the acceleration of the housing boom,” he said. “The boom then resulted in the bust, with delinquencies, foreclosures and toxic assets on the balance sheet of financial institutions in the United States and other countries.”

Taylor said that though policy makers were well intended, they were mistaken in trying to “fine-tune” the economy after about a quarter of a century during which long and deep recessions had been avoided.

“Sticking to the basics, what worked, would have been much better” than to lower interest rates to 1 percent in 2003 to try to revive growth, he said.

Taylor said the Fed’s growing balance sheet is a “systemic risk” because it may be difficult to unwind quickly enough without igniting inflation. The Fed’s balance sheet has more than doubled since last September to about $2 trillion as it purchased government and corporate debt to help unfreeze credit markets and support banks’ demand for cash.

Misguided Proposals

Taylor also said proposals for a systemic risk regulator may be misguided. Such a regulator wouldn’t have prevented the financial crisis, he said.

“If it were given its own regulatory powers, they would be very difficult to limit,” he said. “The experience during the panic last fall is not reassuring that such an agency could resolve private institutions without causing more systemic risks than it was trying to reduce.”

A systemic regulator isn’t a “magic bullet” and its existence could affect the performance of other regulators, he said. “I worry about that a lot, the way government works and the way passing the buck tends to happen,” Taylor said.

The Fed and other regulators need to avoid frequent bailouts of companies, he said, adding that policy makers need clear alternatives to avoid multiple rescues.

“Too big to fail occurs way too often,” he said. “We have a bailout mentality. It has gone too far. It has become a presumption” that large financial firms will be rescued.

Bernanke and U.S. Treasury Secretary Timothy Geithner in March called for new powers to take over and wind down failing financial companies following the government’s rescue of American International Group Inc. They also called for stronger regulation to limit risks taken by firms that could endanger the financial system.

To contact the reporters on this story: Steve Matthews in Atlanta at smatthews@bloomberg.net;

Last Updated: May 13, 2009 00:00 EDT