Wednesday November 4, 2009 - 18:00:12 GMT
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Forex Blog - Could Fed Independence be Reduced, Even Lost with Bank Regulatory Reform?
I am not particularly enthusiastic about the efforts in Washington to rewrite bank regulatory authority law. But it could turn out to be far more significant to Fed independence over the long-run than many think.
Why are the stakes so high? The financial crisis and its impact on the economy (everywhere) has revealed serious weaknesses in macroeconomic
theoryâ€¦discrediting real business cycle advocates, rational expectations crowd (freshwater economists from University of Chicago) and reinvigorated old school Keynesians while forcing neo Keynesians to go back to the basics.
But there is another school of thought in academia that is emerging from the ashes of the crisis as the possible new way for macro theory (see below for WSJ report on Yaleâ€™s Geanakoplos). This new school which Bernanke has a foot in, though hardly a leading proponent, makes a case for banking system plumbing such as supply and price of collateral and leverage are more important determinants of the business cycle and asset prices than official central bank rates which most authorities set as a means for achieving some formal or informal target/s).
I would also like to say that in my wanderings in the financial markets there have been other voices pointing the way to this new approach to macroeconomic theory and its implications for markets, policy and financial stability â€“ James Aitken of Aitken Advisors comes to mind (formerly of UBS).
If indeed econ theory determines in some consensus fashion that monetary policy based on a level for interest rates (to either influence the cost/demand for money and real economic activity and the price level with lags) is flawed policy approach and c banks should switch to focusing on other variables like price and quantity of collateral in the banking system and leverage, we could see a very different world ahead for how assets get priced, expectations form, currency rates are determined. Moreover, monetary policy power will rest more on controls over the plumbing of the banking system and less on level for short term rates. This makes the debate over bank regulatory authority all the more significant and in the final analysis since the Fed blew it so badly on nearly every aspect of the credit crisis from bank leverage, to derivatives (inadequate collateral), not to mention having a checkered record on setting official rates (late to hike, early to ease, keeping rates low for too long), we could see Fed independence lost when US Congress (and legislative process everywhere) is finished with rewriting plumbing rules. In a world where monetary policy is driven by new policy mechanisms like the quantity and price of collateral or bank leverage, things like the Fed funds rate will be secondary and even if the Fed retains control over setting the funds rate, without control over the banking system plumbing through regulatory authority, there will be Fed independence in name only. Are Treasuries priced for this risk? Is the dollar?
Sure we are a long way from central banks like the Fed tossing away its current way of doing things for a new wayâ€¦Bernanke (and Trichet) has yet to embrace adding financial stability as an aim of monetary policy. It is too early in the learning curve to price T and $ for reduced Fed independence impacting the conduct of monetary policy in the near- and medium-term. But decisions now in Congress could determine the long-run independence of the Fed if the new theorists prevail.
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