Don’t change the Fed’s mandate

Writing in the Financial Times, Stephen Roach concludes that it is “[t]ime to revamp the Fed’s flawed mandate.” Roach argues that maintaining financial stability should be added to the Fed’s current dual mandate of maximum employment and price stability.  Such a change would be ineffective at best, destructive at worst.

It would be ineffective because the Fed, like other central banks, already views financial soundness and stability as an integral part of its mission.

The role of central banker as lender of last resort was pioneered by the Bank of England in the eighteenth century–well before Walter Bagehot’s 1873 classic Lombard Street spelled out the duties of a lender of last resort–and remains an important tenant of central bankers today.

The Fed clearly takes this role seriously, as it demonstrated in the aftermath of the 1987 stock market crash and the collapse of Long Term Capital Management.  Formalizing this role, the recently-enacted Dodd-Frank Act puts the Chairman of the Federal Reserve on the new Financial Stability Oversight Council.

The proposal to alter the Fed’s mandate to include financial stability suggests that it should take a more prominent, perhaps even the leading role in the supervision and regulation of financial institutions.  That would be a mistake.

Given the contribution of financial regulation—or the lack thereof–to the current crisis, now is a good time to undertake a thorough review and reform of the US’s supervisory system, a confusing mish-mash of state and federal agencies with overlapping jurisdictions.

Consolidating supervisors is a good idea; consolidating them within the Fed is not.

Central banks have several natural advantages as financial regulators.  They tend to be well-funded and staffed with highly qualified professionals.  Many are endowed by law with a high degree of independence and have earned reputations for being less susceptible to political pressures than other “independent” agencies.  Further, since banking and financial stability are dependent to a large extent upon sound monetary policy, it may be wise to have one entity take the lead in both areas.

The flip side to this synergies-based argument is that the combination of monetary policy-making and banking supervision may lead to a conflict of interest between the central bank’s objectives.  Charles Goodhart and Dirk Schoenmaker show in a 1995 article that central banks with responsibility for banking supervision in the 1980s and 1990s pursued more inflationary monetary policy that those that did not face this dual mission.

The financial crisis has demonstrated that having more financial supervisors than any other country in the world has enhanced neither the safety nor soundness of the American financial system.   The Federal Reserve has an important job: maintaining monetary stability.  This objective should not be diluted or compromised by making the Fed the nation’s chief banking supervisor too.