Expand the Fed's role carefully

Federal Reserve Board Chairman Ben Bernanke's speech last Tuesday attracted the most attention for new mortgage lending rules, to be detailed this week, and for leaving the Fed's doors open to investment banks until next year. But perhaps the most far-reaching item in the speech was his discussion of the proposal in the Department of the Treasury's regulatory-reform blueprint that the Fed be given the formal responsibility of promoting financial stability. At first sight, this seems to be a reasonable proposal. As Mr. Bernanke noted, the Fed already plays that role to some extent. The Fed has been called upon by Congress to help defuse a range of financial crises, in part because it is the only agency that has the power to serve as lender of last resort. But that responsibility has evolved. It hasn't been spelled out in legislation, and if it were, complications would soon arise. The Fed's primary responsibilities are: • To conduct the nation's monetary policy by influencing the monetary and credit conditions in the economy in pursuit of maximum employment, stable prices and moderate long-term interest rates. • To supervise and regulate banking institutions to ensure the safety and soundness of the banking system. These responsibilities contain potential conflicts. Sometimes the pursuit of maximum employment may conflict with the goal of stable prices because the policies necessary to achieve maximum employment may be inflationary. The pursuit of stable prices may conflict with the goal of moderate long-term interest rates because high interest rates may be required to bring down inflationary expectations. When a conflict arises, which way should the Fed lean? Although it is nominally independent, the Fed must work to keep Congress calm for fear that independence could be withdrawn. This forces it to steer a careful course between inflation and unemployment — a course that may not be optimal. What if the Fed were now given the responsibility of maintaining financial stability? Does that responsibility come before or after price stability? From time to time, maintaining financial stability may require the Fed to flood the economy with money, as it did this year to head off the financial crisis brought on by the bursting of the mortgage bubble. How many conflicts can the Fed be expected to juggle at one time? Before the Fed is saddled with a new, formal responsibility, the implications must be carefully examined. If the decision is to go ahead, Congress must say which of the Fed's many responsibilities is its first priority. In addition, as Mr. Bernanke said, giving the Fed formal responsibility for maintaining financial stability makes sense only if its powers are consistent with its responsibilities. Congress, therefore, must be prepared to grant those powers.