Is the Fed wearing so many hats it can't do its main job?

FRIDAY, JUNE 19, 2009
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• http://www.treas.gov/press/releases/tg176.htm

WASHINGTON -- Even before President Barack ObamaBarack Obama outlined his plans this week to revamp the financial regulatory system and expand the powers of the Federal Reserve, the global financial crisis had turned the autonomous central bank into a new institution.

The Fed has been in the forefront of efforts to combat the crisis, and that's made it a target for both criticism and worry. Concerns are only growing with the unveiling of Obama's plan. The fear is that the Fed has taken on so many missions that it may not be as capable as before of doing its main one: ensuring a growing economy with low inflation.

It was the Fed that stepped up in September to rescue failed insurer American International Group. The Fed also stood alongside the Treasury Department in aggressively brokering the sale of investment banks Bear Stearns and Merrill Lynch, institutions it didn't even regulate at the time.

When credit markets seized up last year, the Fed stepped in to lend to corporate America, going well beyond its traditional role of lender of last resort to banks. The move provided needed credit and prevented the economic downturn from growing even worse.

Today the Fed is increasingly taking bundles of residential and commercial mortgages on its balance sheet to help unlock the financing of mortgages and ease the housing slump. That's yet another move outside its traditional activity.

The Fed's primary mission is to try to maintain full employment while ensuring that inflation is low. It does that through controlling the supply of money and credit available to the economy. That's "monetary policy."

Yet the Fed's aggressive lending to fight the crisis has prompted fears that inflation will follow.

"There are already questions in monetary policy about their ability to unwind these facilities they've put in place and reduce their asset holdings," said Alan Levenson, the chief economist for investment manager T. Rowe Price in Baltimore. "What if you need to tighten rapidly to contain inflation? Are you really going to be able to sell $400 billion or $500 billion (of mortgage securities), even if it disrupts the mortgage market?"

For some former Fed board members, the expansion of the Fed's role in the economy is nothing short of breathtaking.

"I think that they've shifted more from being a bank of last resort to right now a bank of first resort, and they're in essence helping to finance and keep afloat more than their traditional commercial banks," Susan Phillips, a Fed governor from 1991 to 1998, said in a recent interview.

"Am I uncomfortable? Yeah, sure. I see them doing things I wouldn't have imagined 20 years ago," said Phillips, now the dean of the George WashingtonGeorge Washington University School of Business. "Having said that, I think we're in a very difficult situation and I am very sympathetic to the need to keep the banking system afloat. I do think these are extraordinary times."

Others see the Fed's evolution as necessary but potentially dangerous, "because Congress can now see that the Fed can do these things," said Larry Kantor, the head of global research in New York for Barclays Capital, a global investment firm.

Kantor, a former Fed staffer, fears that lawmakers may try to politicize the Fed in the future by pressuring it to interfere in credit markets, such as to boost car and home sales or other forms of consumer credit.

"People are more sensitive to anything that even smacks of usurping the Fed's independence, because of the road they've gone down," Kantor said. "It kind of opens a Pandora's Box."

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