Battle for right to dictate Fed’s future

By Krishna Guha in Washington
Published: December 7 2009 19:04 Last updated: December 7 2009 19:04

Two sharply contrasting visions of the future of the Federal Reserve have been thrown into sharp relief by Ben Bernanke’s confirmation hearings in the US Senate.
One of them will emerge triumphant from a protracted legislative battle on Capitol Hill, with big consequences for the way the world’s most powerful central bank does business.
The first is the Bernanke/Geithner model, advocated by the Fed chairman and his former colleague Tim Geithner, Treasury secretary. Call it the “broad Fed”.
A broad Fed would keep its banking supervision authorities and bolt on to them new systemic risk or “macroprudential” powers. It would be a fully-fledged financial stability agency as well as a monetary policy agency.
The second model is the Dodd model, proposed by Senate banking committee chairman Chris Dodd. Call it the “narrow Fed”.
A narrow Fed would lose its banking supervision authorities and would play a subordinate role in a new systemic risk agency. It would be focused on monetary policy.
Which is the better model? In favour of the narrow Fed model, the central bank’s record in bank supervision is far from stellar. There are obvious benefits to moving to consolidating bank regulation.
The Fed does not (or need not) have a monopoly of regulator talent. A separate systemic risk agency could in principle harness multiple institutional perspectives on emerging threats. Meanwhile, tighter focus on monetary policy would make it easier for the central bank to retain the independence central to effective monetary policymaking.
Moreover, the Fed’s claim that being a banking regulator helps it make monetary policy is questionable, as Mr Bernanke more or less conceded at the hearings.
The case for a broad Fed as opposed to a narrow Fed is not fundamentally about monetary policy. It is about financial stability policy. During the financial crisis the Fed benefited greatly from its understanding of the plumbing of the banking system. This made it an effective and innovative lender of last resort.
Advocates of a narrow Fed argue that, in their model, the central bank would still be able to access any information it wants. But there is a difference between information and the expertise to interpret that information. It seems reasonable to assume that a Fed that lost banking supervision powers would lose some of its expertise in banking too.
Experience in the UK and elsewhere supports the broad Fed case. “One of the main lessons of the crisis may be that those countries where central banks assume banking supervision took advantage of their ability to react quickly and flexibly to emergency situations,” said Christian Noyer, governor of the Banque de France, in a speech earlier this year.
A broad Fed may also be the most effective way to prevent the build-up of threats to financial stability in normal times.
In a narrow Fed model a separate agency would decide when to use controls on risk-taking to target emerging excesses. But this would be difficult to co-ordinate with monetary policy, which has to respond to the same developments and which operates through the same channel – the credit channel.
However, advocates of the broad Fed model have to get to grips with the genuine political economy issues their approach raises. The Fed has enjoyed a unique degree of autonomy in the US system because it has been seen to focus narrowly on monetary policy.
The wider its role and the more it extends even in normal times into sectoral allocation of credit, the more scrutiny it justly demands. Advocates of a broad Fed have to provide richer answers to these concerns.
It is hard to argue that macroprudential policy is so closely intertwined with monetary policy as to be institutionally inseparable and yet suggest that the governance regimes can be completely distinct.
There is in fact a reasonable basis for drawing a distinction – between tools that affect the whole economy without discrimination (interest rates) and those that affect particular parts of the economy (regulatory tools). But a broad Fed may have to learn to live in general with a greater degree of public scrutiny.