The Federal Reserve's Financial Stability Mandate: Adapting Monetary Policy's Role in an Era of Macroprudential Regulation
The Blake School
After both the Panic of 1907 and the financial crisis of 2008, public attention turned to protecting the financial system from future shocks. In the twentieth century, the Federal Reserve was created as a lender of last resort.1 in the twenty-first century, the challenge of protecting the system has been complicated both by the Fed's expanded tools and by increases in size and complexity of the financial system.2 Promoting financial stability will continue to be an important question for the Federal Reserve, and analyzing the role of monetary policy in promoting financial stability is especially relevant today in the aftermath of the 2008 crisis and in celebrating the Fed's centennial anniversary.3 This paper argues that the Federal Reserve should have an explicit financial stability mandate that guides it to (1) monitor and research financial stability and (2) consider using both ex-ante and ex-post tools to address financial instabilities, such as asset bubbles.
The 2008 crisis revealed systemic risk due to interconnectedness and regulatory gaps, prompting a policy shift for many federal agencies from a traditional, microprudential focus on "the safety and soundness of individual financial institutions" to a "macroprudential approach [that] also calls for attention to the financial system as a whole."4 This shift was made explicit in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which requires regulators to take a macroprudential approach and created the Financial Stability Oversight Council (FSOC) to monitor systemic risk and orchestrate macroprudential efforts through public recommendations.5 This Act and similar reforms around the world may mark a turning point in economic policy and the start of a macroprudential era.6 In this era, the Fed needs an explicit financial stability mandate. While the Fed has long acted to promote financial stability, the 2008 crisis revealed that the current implicit mandate, which only guides the Fed to consider the stability of individual components (i.e.: a microprudential focus), is insufficient.7 An explicit financial stability mandate can guide the Fed to adopt a macroprudential focus, help avoid inter-agency disputes over policy boundaries, and allow the Fed to take difficult, yet necessary, measures without fear of backlash for overstepping its bounds.8
The mandate's first provision should guide the Federal Reserve to monitor and research financial stability, especially in the context of monetary policy's impact on stability. Many conservative economists have long written about the potential for quantitative easing to create asset bubbles, and even Chairwoman Yellen, who supports the program, acknowledged its "potential risks for financial stability" in her confirmation hearing. In a departure from Greenspan-era thinking, Yellen argued "it is important for the Fed ... to detect asset bubbles when they are forming" and respond to them.9 Monitoring bubbles, though difficult, will help shape future monetary policy, such as how to balance quantitative easing (higher risk of asset bubbles) and forward guidance over risk of bubbles).10 Continued attention and new research to improve monitoring and detection capabilities will be needed, along with monetary policy driven first and foremost by financial data.11 Although the Dodd-Frank Act houses the main financial research body (the Office of Financial Research (OFR)) in the Treasury, the Fed has an important role in macroprudential research because of its internationally renowned economic research team and unique perspective on macroprudential monetary policy. The Fed-and its newly minted Office of Financial Stability Policy and Research, in particular-can complement the Office of Financial Research by focusing on macroprudential monetary policy, while the 0FR researches macroprudential regulation. This will certainly require clear information sharing protocols.12
In addition to research, the Fed's stability mandate should guide it to consider utilizing both ex-ante and ex-post tools to address financial instabilities, such as asset bubbles. Prior to the 2008 crisis, the 'Greenspan doctrine' that "ex-ante intervention to prevent booms are too costly compared to [ex-post] 'mopping up' measures after a financial crisis" was widely accepted.13 Under this view, regulatory tools are preferred to ex-ante monetary policy because they are more targeted and less likely to slow down the overall economy; the disadvantage, however, is that such targeted approaches miss undetected financial risks.14 The new focus on macroprudential policy signifies a major departure from this doctrine and the belief that both ex-ante and ex-post measures may be necessary.15 But while ex-ante regulatory measures to prevent crises are now widely recognized as necessary, ex-ante monetary policy actions remain controversial.
Indeed, that monetary policy is a blunt tool is its blessing and its curse: using it risks slowing economic activity, but "it gets in all of the cracks" because all economic actors are affected.16 Targeted approaches may miss some cracks, either because they cannot curtail ce1tain risks or because some cracks go unnoticed.17 There are several other limitations to supervision and regulation that merit consideration of ex-ante monetary policy-for example, recent partisan gridlock could hamper ex-ante Congressional responses to bubbles.18 Further, the Fed's increased number of instruments for monetary policy enables it to act on bubbles without neglecting its original dual mandate, as critics previously worried.19 Using monetary policy to prevent bubbles is certainly not desirable in every situation; for well-identified bubbles, targeted approaches may offer comparable effectiveness without slowing down the economy. Perhaps monetary policy is best for situations of general frothiness (instability) or as a second line of defense when supervision and regulation don't suffice.20 Improved monitoring capabilities may one day obviate the need for ex-ante monetary policy to address financial instabilities, but the 2008 financial crisis makes clear that capabilities are not yet at this level. While deciding which instabilities merit ex-ante monetary policy is an ongoing debate, two things are clear: (1) this debate deserves attention, and (2) ex-ante monetary policy should at least be considered.
The 2008 financial crisis emphasized the importance of a macroprudential approach to understanding and promoting financial stability. Since then, economic researchers have explored macroprudential regulation, and governments across the world have taken steps to shift regulatory frameworks accordingly, with the United States playing a prominent role in its 2010 Dodd-Frank Act. In the next 100 years, the quintessential question will remain deciding the Fed's role in promoting financial stability, but this question, and the Fed itself, will take on an entirely different character in an era of macroprudential regulation, greater monetary policy tools, and increased complexity in the financial system. This paper argued that the Federal Reserve should have an explicit financial stability mandate that guides it to (1) monitor and research financial stability to inform monetary policy decisions, and (2) consider utilizing both ex-ante and ex-post tools (specifically, macroprudential monetary policy) to address financial instabilities, such as asset bubbles, as a complement to macroprudential regulation. Adapting the Federal Reserve to meet society's needs in this era of change will certainly be challenging, but it is of critical importance that the Federal Reserve meets this challenge.