Don't end the Fed, split it in two

One of my favorite thinkers on monetary policy is soon-to-be-former Deputy Director of the Riksbank Lars Svensson. Sweden was fortunate enough to have not been part of the euro in 2008, and was able to use expansionary monetary policy to avoid the worst of the 2009 recession. Their success was due, in part, to their willingness to pioneer new policy tools, like negative interest rates.

Since 2010, Svensson has regularly dissented from the Riksbank's decisions to tighten policy. His argument for looser policy is simple: unemployment is below the target rate, and long-term inflation expectations remain anchored, therefore, policy is too tight. If the central bank projects that looser policy would reduce unemployment, without raising long-term inflation expectations, they should loosen policy.

His views, and disagreements with other members of the Riksbank, are nicely explicated in this speech he gave last year. The other members of the Riksbank are concerned that looser monetary policy will lead households to take out larger mortgages, increase household debt, create a housing bubble, and cause financial instability. Svensson argues that these aren't concerns in Sweden right now. But his more important argument is that even if these were problems, monetary policy would not be the appropriate tool for dealing with them.

First, monetary policy isn't very effective at preventing housing bubbles. Second, other policy tools--mortgage-lending rules, capital requirements, etc.--would be more effective and more appropriate for maintaining financial stability. Svennson refers to these tools as "macroprudential policy", but it is what most of us think of as financial regulation. Matt Yglesias makes a similar point in a recent post, noting that: "If full employment exists and inflation is low and stable, then you should not deliberately engineer a recession for the sake of financial stability."

Even though monetary policy and financial stabilization have separate policy goals--the managing of risk within the financial system and macroeconomic stabilization, respectively--they are often conflated in discussions about policy. One of the sources of confusion is that both monetary policy and financial regulation are associated with a single institution--the Federal Reserve.

The conflation of the two policy goals has lead to reduced accountability, and a non-optimal use of expertise at the Fed. Because Fed officials are considered responsible for both tasks, the public has a difficult time determining how well they performed at each one separately. The best example of this is Alan Greenspan, who, for the most part, kept both unemployment and inflation low (signs of successful monetary policy), but also oversaw a withering away of lending standards and a large buildup of systemic risk (signs of failed macroprudential policy). Though his reputation has suffered since the crisis, the criticism of him is often of a general nature, with a failure to distinguish his real (and substantial) failings, from the aspects of his job that he performed well at. I am not trying to make a point about Greenspan being treated unfairly, but rather the way confusion about this topic reduces accountability. The current structure of the Fed also gives officials responsibilities for which they are not ideally suited. Some members of the Federal Reserve Board of Governors, for instance, Daniel Tarullo, are experts in financial regulation and macroprudential policy, but have no real background in monetary policy. Other members, such as Janet Yellen, are primarily monetary policy experts. It is not optimal to have these specialists spending time focusing on areas of policy over which they have no expertise.

In many instances, the proper coordination of financial regulation and monetary policy requires the regimes to work at, what superficially appears to be, cross-purposes. For example, if regulatory authorities felt that major financial institutions were overleveraged and at risk, they would need to require these institutions to raise equity ratios. This would usually cause a reduction in lending by these institutions, which would slow down economic activity. Monetary policy authorities should respond to these developments by loosening monetary policy, in order to prevent the slow down. This is counter-intuitive, but keeping the two policy goals separate helps clarify the correct policy action. Because we conflate these two goals, we often hear policy makers arguing that the Fed needs to tighten monetary policy to increase financial stability.

I haven't ironed out exactly how this should all work. Certain tasks, like operating the discount window, probably fall within the purview of both policy areas. I would love to hear other peoples thoughts on this subject.

P.S. Read Lords of Finance if you are interested in how similar confusion helped lead to the great depression. Also, read Jeremy Stein's recent speech if you want the opposing argument.