There have been some newsworthy moments for the Federal Reserve in the last few years, but the general public must wonder why the central bank is on the front page with such regularity these days. Whether it's about the tapering of its quantitative easing policy or the appointment of a new chairman to replace Ben Bernanke, the Fed has been a focal point for pundits and policy thinkers alike.
I suppose when you are responsible for keeping markets and the economy on track, attention is expected. But the financial crisis, which came to a head with the failure of Lehman Brothers just five years ago last Sunday, showed us just how important the Fed is.
The Fed's focus on inflation as the only constraint on stimulating growth in the mid-2000s allowed imbalances to develop in housing that set the stage for the bubble. The crisis was amplified by fragility in the financial system that grew up outside the Fed's supervisory purview. Safety and soundness did not get the attention they deserved in the regulation of non-bank broker-dealers like Bear Stearns and Lehman Brothers, a subsidiary of insurance giant AIG, the commercial paper market and money market mutual funds. And finally, the Fed acted courageously to forestall what could have been a much deeper crisis with more than $1 trillion in lender-of-last-resort assistance.
The next chairman will be challenged to lead the Federal Reserve System in all three areas. Monetary policy will have to continue to create the conditions necessary for job creation and income growth while avoiding both inflation and a buildup of imbalances that could end in another crisis. The consensus view of central bankers before the crisis that inflation targeting was all that was needed will need to be re-examined and new policy tools will be necessary to meet a broader set of objectives.
The Dodd-Frank financial reform law responded to the lack of a systemic supervisor by creating a framework for monitoring systemic risk via the so-called Financial Stability Oversight Council. The Fed will play a dual role in the council, both as the regulator of all bank holding companies and some banks, and as a critical voice for sound supervision across the entire financial system. The Oversight Council can only be effective if the Fed is strong within it as a voice for safety and soundness across the financial system.
The third role of the Fed in the crisis – much to the chagrin of critics of the Federal Reserve and the government's support of large financial institutions – may be the most important. Maintaining the Fed's ability to serve as a lender of last resort is one of the most important things we can do to insulate the economy from financial distress. Dodd-Frank limited the Fed's independence by bringing the Secretary of the Treasury into any use of emergency lending authority. In my view, calls for further restrictions on the Fed as a lender-of-last resort should be carefully considered.
Those calling for further restrictions would do well to examine how much closer we would have been in 2008 to a crisis much deeper than the one that we lived through were it not for the actions of the Federal Reserve. The Fed took unprecedented action to immediately reduce the damage of the crisis. It did so by providing support where there was good assurance of repayment and a cost to those receiving support that reduced moral hazard. It will recover all of the funds that it committed without loss to the taxpayer. When it comes to investing in a stronger financial system, preserving the power of the Federal Reserve to serve as a lender of last resort is perhaps the highest return on investment we can make.
The next Fed chairman will have a long to-do list: he or she must set forth an appropriate monetary policy that weans markets off of the quantitative easing program the Fed has employed in the aftermath of the crisis. As well, it must oversee a critical supervisory role, which has not yet been fully defined. But re-establishing public support for the Fed's ability to serve as a lender of last resort may be the most difficult and important challenge that the next chairman or woman will face in order to safeguard the economy in the next financial crisis. That one should be at the top of the list.