Wednesday, July 16, 2008

Dual-plus-one mandate 

Yesterday's monetary policy testimony to Congress has painted Ben Bernanke as veering back to easy money.
So soon after we were told that central bankers had "figured it out", that previous inflations were due to insufficient knowledge or the use of a bad macro-model and that the era of inflation was over, we are heading right back into the soup. Yes I know that unemployment and recession are painful experiences that should be avoided if possible. But I also know that the one thing the Fed actually can control is inflation. I am not so sure they can provide a monetary solution to an adverse real event (or sequence of events).
This morning, in light of that CPI report, Bernanke reiterated his commitment to price stability, though he laid blame on factors in energy prices that are "outside the control of the Federal Reserve."

But truth be told, the Fed's mandate is to provide solutions to adverse real events. From Bernanke's testimony yesterday:
In mid-March, a major investment bank, The Bear Stearns Companies, Inc., was pushed to the brink of failure after suddenly losing access to short-term financing markets. The Federal Reserve judged that a disorderly failure of Bear Stearns would pose a serious threat to overall financial stability and would most likely have significant adverse implications for the U.S. economy. After discussions with the Securities and Exchange Commission and in consultation with the Treasury, we invoked emergency authorities to provide special financing to facilitate the acquisition of Bear Stearns by JPMorgan Chase & Co. In addition, the Federal Reserve used emergency authorities to establish two new facilities to provide backstop liquidity to primary dealers, with the goals of stabilizing financial conditions and increasing the availability of credit to the broader economy.
Like it or not, that's their job. Now we find discussions, including yesterday's testimony after which Bernanke was joined by the heads of the Treasury and the SEC, to expand that mandate to include a third. Bernanke spoke about this last week.

Another possible step to reduce the incidence and severity of financial crises, recently proposed in the Treasury blueprint for regulatory reform, would be to task the Federal Reserve with promoting the overall stability of financial markets. To some extent, the Fed already plays that role, and indeed its founding in 1913 was prompted largely by the desire of the Congress to address the problem of recurring financial panics. In recent decades, the Federal Reserve has figured prominently in the government's attempts to address a range of financial crises, in part because of the broad expertise derived from the Fed's wide range of activities. Moreover, the Fed is the only agency that has the power to serve as a liquidity provider of last resort, a power that has proved critical in financial crises throughout history.

That said, holding the Fed more formally accountable for promoting financial stability makes sense only if the institution's powers are consistent with its responsibilities. In particular, as a practical matter, I do not think that the Fed could fully meet these objectives without the authority to directly examine banks and other financial institutions that are subject to prudential regulation. During the recent financial turmoil, the ability of the Fed to obtain information directly from key institutions and from supervisory reviews has been invaluable for understanding financial developments and their implications for the economy. To fulfill its responsibilities, the Fed would also need to have the ability to look at financial firms as a whole, much as we do today when we exercise our umbrella authority over financial holding companies, and the authority to set expectations and require corrective actions as warranted in cases in which firms' actions have potential implications for financial stability. Finally, to identify financial vulnerabilities, the Fed would need general authority to collect information on the structure and workings of financial markets. In particular, the recent experience has clearly illustrated the importance, for the purpose of promoting financial stability, of having detailed information about money markets and the activities of borrowers and lenders in those markets.

If the Congress chooses to go in this direction, attention should be paid to the risk that market participants might incorrectly view the Fed as a source of unconditional support for financial institutions and markets, which could lead to an unacceptable reduction in market discipline. If the Federal Reserve's formal mandate were broadened to encompass financial stability, it would be particularly important to make clear that any government intervention to avoid the disorderly liquidation of firms on the verge of bankruptcy should use clearly defined tools and processes, along the lines I discussed earlier.

It's an intriguing speech, which Justin Fox reviews, describing Bernanke as walking a tightrope. Senator Jim Bunning thinks the Fed has fallen off the rope, while I would argue they've muddled through pretty well, consistent with what they've always done in this situation.

Bordo and Wheelock [1998] examine the hypothesis that price stability and financial stability go hand in hand (first promulgated by Anna Schwartz). They found informally that for the USA, Canada and the UK, the two were in fact linked up. They conclude
Regardless of what triggers financial distress, be it monetary or nonmonetary forces, the most severe episodes of instability have occurred typically in disinflationary environments. This has not always been true, however. Severe banking panics occurred in the United States in the late nineteenth and early twentieth centuries, when the price level was comparatively stable. Still, before the Civil War, during the Great Depression, and since World War II, financial distress was typically most severe during periods of substantial disinflation. The historical record thus suggests that a monetary policy that focuses on limiting fluctuations in the price level will tend also to promote financial stability.
Clearly within the housing sector we are seeing a period of disinflation that will end up causing the same kinds of dislocations as Bordo and Wheelock documented. In this situation, whether or not real interest rates in the US are positive or negative probably doesn't matter very much; they are just allowing banks a little breathing room to repair their balance sheets.

So does the dual mandate (or triple?) mean the Fed is doing it wrong? Charles Wyplosz is a little more charitable than Angus.
Why should it, on the one hand, provide ample liquidity against second-rate collateral and, on the other hand, maintain high real interest rate, especially as the Treasury mail checks to US citizens? Yet, the amazing reduction of interest rates in the wake of irresponsible bank behavior through a credit cycle leaves the painful impression that moral hazard is officially accepted as a fact of life. The Fed may note, however, that many banks have suffered severe losses and that their shareholders have seen some dilution of their assets as capital has been raised. The new Bagehot rule seems to be: banks are bailed out indirectly via low real rates and the ability of swapping toxic assets against liquidity while their shareholders take a beating and some top managers are made redundant. ...

Central banks are going through a rough patch. Oil shocks are technically easy � prevent inflation from setting in � but politically delicate � allow for rising unemployment � to deal with. Financial crises are always delicate because they are always different, largely because lessons from the previous have been learnt. High food prices additionally complicate the picture. Facing different situations, the Fed and the ECB muddle through, each in its own way. They could have done it differently, maybe, but it is fair to say: �so far, so good�.
If the liquidity the Fed is issuing is being hoarded to balance sheets and not passing through to lending it would also not pass through to inflationary expectations. Today's CPI reading would have you believe something a little different than that. But while a core rate rise towards 3% is concerning, central banks with dual mandates may decide it's a price they need to pay.

UPDATE: Bleak notes that Bernanke's job isn't easy and lays some of the blame on Greenspan. As Jim Rome would say, concurrrrrrrrr!

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