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Fed's Crisis Role Spurs Questions of Overreach

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By Neil Irwin
Washington Post Staff Writer
Thursday, July 17, 2008

The sprawling financial and economic crisis is leading to expansion of the Federal Reserve's role, increasingly turning the central bank into a sort of all-purpose guarantor of the financial system.

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In the past few months, Fed Chairman Ben S. Bernanke has burst through long-standing boundaries on what the Fed does. Bernanke's actions -- many taken reluctantly -- have repeatedly pulled the world from the brink of financial catastrophe and have won praise from Wall Street and Capitol Hill.

But as it gains a broader portfolio of responsibilities and expectations, the Fed risks losing its focus on managing the nation's monetary policy, say some who study the institution. And it even could create risks to the central bank's credibility and its fiercely guarded independence.

"The Federal Reserve has re-created itself," said Vincent Reinhart, a senior staffer at the Fed until last summer who is now a resident scholar at the American Enterprise Institute. "And if you do more things, you set yourself up to have to choose among them and trade off. What happens when concern for housing finance conflicts with the need to pursue price stability?"

Last weekend, Bernanke offered Fed lending to the housing finance companies Fannie Mae and Freddie Mac and did not resist in gaining a new role for the Fed in setting those firms' capital requirements. In March, the Fed engineered the buyout of Bear Stearns and offered emergency lending to all investment banks.

The Bush administration has proposed formally making the Fed responsible for financial stability. Bernanke has said that if that were to happen, the central bank would need power to match the new responsibility.

The central bank has long had a "dual mandate" of maintaining price stability and low unemployment, with an unofficial role of maintaining stability in the financial world. The legal change, which congressional leaders have signaled openness to, could essentially turn it into a three-way mandate.

That could have unpredictable consequences. For example, if the Fed in the future were to fail to prevent a crisis, it might undermine the credibility of the institution as a guardian of economic growth and low inflation.

"It's reasonable to ask, 'Is it optimal to have the same organization perform both a financial-stability function and a price-stability function?' " said Neal Soss, chief economist of Credit Suisse. "And if so, how do you structure the organization so it can perform both?"

Bernanke and his inner circle say responsibility for financial stability is so deeply intertwined with making monetary policy that the two roles complement each other. Indeed, the central bank was founded in response to banking panics in the early 20th century, and its role managing the money supply evolved later.

"The Fed has several missions, and monetary policy is the primary one," said Alice Rivlin, a Brookings Institution scholar and former Fed vice chairman. "But they also have a mission to stabilize the banking system, and we're in the process of expanding our view of what the banking system is."

Bernanke and his associates say the more unorthodox steps they've taken were a response to an epic financial crisis and don't necessarily mean that the broader role for the Fed will be permanent. And they are hopeful that Congress will take steps that would prevent such intervention by the Fed from being necessary in the future, for example by setting up a process for dissolving a failed investment bank and finding a long-term structure for Fannie Mae and Freddie Mac that makes sense.


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