Financial reform will make the Fed more powerful and less independent (TheEconomist)

Central banks under scrutiny

Prometheus bound

Financial reform will make the Fed more powerful and less independent

May 20th 2010 | WASHINGTON, DC | From The Economist print edition

THE decision of the European Central Bank to start buying government bonds follows a path trodden by the Federal Reserve in 2008 and 2009. Both entered politically charged territory to save the financial system at great risk to their reputations. For the Fed, one consequence is that the big financial-reform bill making its way through the Senate—a vote was expected after The Economist went to press—will leave it more powerful but more beholden to Washington, DC.

The Fed has fought for, and kept, its supervision of banks. It acquires important new powers to regulate big non-bank financial companies and even to break up firms deemed a threat to the financial system. Its only significant loss of turf is direct oversight of consumer protection. The Fed keeps its emergency-lending powers, though it needs the Treasury’s approval to use them (it has usually sought such approval anyway). It cannot lend to failing firms because that job now sits with the Federal Deposit Insurance Corporation under the bill’s new resolution authority.

The price of these powers, though, is to be drawn closer into politicians’ embrace. Since its birth the Fed’s governance has reflected a mix of political and financial influences. Monetary policy is the joint responsibility of governors in Washington, DC, appointed by the president and confirmed by the Senate, and presidents of the reserve banks, some of whose directors are, or are appointed by, bankers.

Critics have long seen the bankers’ role in the running of the Fed as an affront to democracy. Under the reform bill the president will now nominate and the Senate will confirm the New York Fed president (the most important of the regional governors). Fed-supervised banks will lose any say in the governance of the reserve banks. Barney Frank, the chairman of the House Financial Services Committee, wants to go further, either stripping all reserve-bank presidents of their votes on monetary policy or making them more accountable.

Such changes have some worried that the Fed will adopt a looser monetary stance. In the near term, these fears are overdone. The economic environment remains deflationary. Excluding food and energy, inflation fell to a 49-year low of 0.9% in April. Political pressure for more expansionary policy has also been surprisingly slight. Opponents of Ben Bernanke’s confirmation to a second term as Fed chairman in January were more likely to criticise lax policy before the crisis and the Fed’s interventions during it, not its failure to maintain full employment. Inside the Fed, the pressure is also for tighter policy. Some officials are pressing for a quick sale of its holdings of mortgage-backed securities, although minutes of its April meeting suggest that will not happen before the Fed begins raising short-term rates.

The greater risk to Fed independence is not pressure from outside, but the temptation from inside to broaden its macroeconomic remit as the lines between regulatory and monetary policy blur. Financial stability has been formally added to the Fed’s duties, alongside full employment and price stability. More governors will be chosen for regulatory and legal expertise; one will be designated vice-chairman for supervision. If Barack Obama’s latest nominees are approved, only three of the seven governors will be economists; two will be lawyers. Decisions on which financial firms to regulate, which to support and which to liquidate will increasingly be made with an eye on the broader economy. Interest-rate decisions will more heavily consider the impact on the financial system. A hard job has got harder.