Thursday, December 3, 2009

Fed independence - what might be the most important fight

Fed independence is critical to the functioning of the US economy. This is not overstating the case. The standing of the US in international markets is affected by the perception of the Fed as having control of money without influence from the government. If the Fed is viewed as less independent, or have less creditability, then there will be a greater inflation premium added to bonds. Rates will go up based on the perceived risk that the Fed will allow inflation to increase in order to meet the needs of government for full employment. The requiring of a monetary policy audits will place the Fed under greater control of Congress.

Of course, the Fed is political and not completely independent of what is happening in the fiscal realm. It has a dual role because of the Humphrey-Hawkins Bill which has the Fed base decisions on both inflation and full employment. Nevertheless, the Chariman of the Fed has the special responsibility to hold off desires of Congress to manipulate monetary policy. In exchange, the Fed is supposed to avoid commenting on fiscal matters.

The key issues will not be decided during the Bernanke confirmaton hearings, but this will be the focus of what may occur in 2010. There are two issues that are relevant during the confirmation hearings:

1. Will Congress move to have formal audits of the monetary policy function of the Fed? This oversight would go beyond the normal hearings as part of the Humphrey-Hawkins Bill. Congress is also looking into many issues of Fed structure including the organization of the regional banks and how directors are picked.

2. What should be the regulatory function of the Fed? The issue is whether the Fed should be given additional powers to supervise financial firms. Bernanke argues that this power is essential to maintain control over monetary policy. Congress is arguing that the supervision job the Fed has done in the past may require that a different agency conducts this oversight.

The current system of multiple regulators was inefficient and a contributor to the crisis, but this does not mean that the Fed should have this responsibility. The Fed needs information on the behavior of financial institutions and the economy to understand what actions should be taken in the pursuit of monetary policy, but it is less clear that they need to be the super-regulator.

Who would have thought that these complex issues would be the focus on the Fed chairman confirmation hearings? However, the Fed has put itself in this condition because of the job it has done of the last few years. Could this crisis have been avoided? Unclear. What is clear is that it could have been better at raising rates at the end of the Greenspan era. It contributed to the housing bubble. It should have been better in regulating banks and monitoring the financial system. It could have slowed the speculation. It should have been better at controlling the crisis in the period from July 2007 through the end of 2008. It should have been planning for systemic risks.

Now there is a time for accounting. The audit is on.

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