Central Banks

Friday, April 27, 2012 - 15:16

Analysis: Fed Faces Conflict Between Monetary, Regul'y Pol -3


As Bernanke noted in his Wednesday afternoon press conference, Dodd-Frank was designed to circumvent the "too-big-to-fail" problem by giving the Federal Deposit Insurance Corporation authority to do an "orderly liquidation" of a failing big bank. But there is widespread skepticism that it will work in practice.

"I'm concerned that we haven't solved that problem," Philadelphia Fed President Charles Plosser said last month. "In some sense we have made it worse because we have bigger banks."

More recently, Kansas City Fed President Esther George said "the most critical issue in addressing TBTF concerns is having policymakers with the resolve to follow through. In a crisis, there will always be concerns about creditor or depositor panics, public confidence issues, interconnections with other institutions and disruptions in financial services. While I believe these concerns often are exaggerated and can be minimized through the resolution frameworks we now have in place, others will almost certainly have different views."

Rosenblum warned that, in the next crisis, "a nightmare scenario of several big banks requiring attention might still overwhelm even the most far-reaching regulatory scheme. In all likelihood, TBTF could again become TMTF-too many to fail, as happened in 2008."

"While decrying TBTF, Dodd-Frank lays out conditions for sidestepping the law's proscriptions on aiding financial institutions," he wrote, "In the future, the ultimate decision won't rest with the Fed but with the Treasury secretary and, therefore, the president. The shift puts an increasingly political cast on whether to rescue a systemically important financial institution."

Rosenblum concluded that "for all its bluster, Dodd-Frank leaves TBTF entrenched."

Recognizing that there are regulatory and other non-monetary forces clogging the credit channels has not resolved the FOMC's policy dilemma. This was illustrated at a Monetary Policy Forum sponsored by the University of Chicago Booth School of Business in late February.

Williams, an FOMC voter, earlier acknowledged that the "monetary transmission mechanism" is "clogged" due to housing and mortgage credit problems. But, rather than that being a reason for the Fed to back off on monetary easing, he said "if the channels are clogged we need to do more."

But St. Louis Fed President James Bullard said he "would disagree with the idea that because it's clogged up we have to push even harder."

"If you try to push so hard on monetary policy even when the mechanism isn't really working, the whole thing blows up on you and you get a lot of other problems," Bullard warned.

If and when reserves start flowing rapidly into the economy through banks' lending windows, the Fed has said it is prepared to raise the interest rate it pays on excess reserves (the IOER) to curb the pace of money and credit growth.

After it starts raising the IOER and the federal funds rate, the Fed would allow some passive shrinkage of its balance sheet by ceasing to reinvest principal payments from its holdings of agency debt and agency mortgage-backed securities in other securities and perhaps by ceasing to roll over maturing Treasury securities at auction. At some point, the Fed would more actively reduce the size of the balance sheet

-- and bank reserves -- by selling assets.

But such tightening measures appear to be far off. For now, the FOMC will continue to chafe at credit constraints largely beyond its control.

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