By Pedro Nicolaci da Costa

NEW YORK (Reuters) - The Federal Reserve's decision to cut interest rates in response to the U.S. financial market crisis of the past year is a bad mistake that will lead to higher inflation, a former Bank of England official said on Saturday.

In a paper presented at the Federal Reserve's annual conference in Jackson Hole, Wyoming, the London School of Economics professor Willem Buiter, comes down hard on the Fed for misjudging the effects of the U.S. housing market slump.

"The Fed over-reacted to the slowdown in economic activity," Buiter writes. "It cut the official policy rate too fast and too far and risked its reputation for being serious about inflation."

"The official policy rate is a rather ineffective tool for addressing liquidity and solvency issues," he adds.

As rising default rates on home mortgages and falling house prices in the U.S. housing market impacted the value of financial assets worldwide in the past year, the Fed cut its benchmark borrowing rate down to from 5.25 percent last summer to the current 2.0 percent, and has held them steady at the past two policy meetings.

Buiter agrees with the general consensus at the Fed, which is only now beginning to be questioned, that asset price bubbles cannot be adequately dealt with through monetary policy.

However, Buiter writes that proper regulation might have done what the federal funds rate cannot. By sitting idly by while investment banks and hedge funds were taking wild risks in financial markets, the Fed itself holds some responsibility for the developments of the past year, the author argues.

"I do not agree that the best that can be done is for the authorities to clean up the mess after the bubble bursts," says Buiter.