The Fed's Price & Financial Stability Mandates: Conflict As Manager of Monetary Policy & Regulator
The Fed faces a precarious balancing act as it tries to curtail inflationary pressures with its official rate tool and uses its macroprudential authority to deal with a banking crisis. The Fed has always separated the two mandates, but its reasoning is flawed.
For example, Former Fed Chair Janet Yellen has argued, "Monetary policy faces significant limitations as a tool to promote financial stability...efforts to promote financial stability through adjustments in interest rates would increase the volatility of inflation and employment. As a result, I believe a macroprudential approach to supervision and regulation needs to play the primary role."
Yellen's argument ignores how adjustments in interest rates ( easy money) can lead to financial instability. Easy money policy has followed every economic and financial crisis of the past twenty-five years, leading to the next problem. The Fed can never eliminate lousy management practices or excessive risk-taking, but it should be more aware that its policies can create imbalances and instability.
The Fed faces a critical test. Does it abide by its principles and continue to raise official rates to curtail inflation, or does it cave into the calls for a relaxed monetary policy after Silicon Valley and Signature Bank failures?
Arguments that if the Fed did not act, innovation in America would be dead for the next decade is nonsense. Innovation linked to easy money is not innovation; it's speculation.
SVB and SIG's demise represents lousy risk management and the failure of the Fed's regulatory and supervisory roles. It happened again just like it did in the 1980s with the failure of Continental Illinois, in the 1990s with Orange County and Long-Term Capital, and in the 2000s with Lehman, AIG, and others. Richard Fisher, former President of the Federal Reserve Bank of Dallas, stated, "Macroprudential supervision is something of a Maginot line: It can be circumvented."
Suppose the Fed alters its monetary policy course after this. In that case, it will set a bad precedent as it will endorse the use of monetary policy when the macroprudential supervisory function is circumvented or fails. It will also send another message--- the more significant the screw-up and investor losses, the greater the odds the Fed will bail you out. The Fed needs to save the financial system, but it also needs to save itself.
The Fed must acknowledge that its policies can and have distorted financial markets to retain its autonomy and respect. Restoring itself to be more like a traditional central bank will be challenging, but its dual role as the driver of economic activity and regulator has failed.