Clarifying the Role of the Federal Reserve in an Economic Crisis

Published on April 06, 2009

Expectations about future actions by policymakers play an important role in the economics of a wide array of decisions made by businesses and households, said Charles Plosser, MBA ’72, PhD ’76, president and CEO of the Federal Reserve Bank of Philadelphia.

“This has been one of the most significant developments in economic theory during the last four decades, and much of this work was pioneered here at the University of Chicago,” Plosser said during the Distinguished Speaker Series, sponsored by the Graduate Business Council, at Harper Center on March 31.

Recognition of the interaction between policies and expectations is the basis of four principles for sound central banking, he said. Those principles are:

1. Policymakers should set clear objectives that are realistic and feasible.

2. Policymakers must make a credible commitment to conducting policy in a systematic way over time, even when it seems expedient to do otherwise.

3. Policymakers must transparently communicate their policies and actions to the public.

4. The central bank must be able to pursue its policies independently of the political process and fiscal authority.

These four principles can help improve policymaking in three areas related to the current financial crisis: (1) managing the central bank’s role as lender of last resort; (2) dealing with firms that are too big to fail; and (3) determining the Federal Reserve’s role in promoting financial stability, Plosser said.

“We must develop much clearer criteria under which the Fed will lend to banks or nonbank financial institutions, because the lack of clarity about the purposes of our lending programs and their criteria has added uncertainty and volatility to the markets,” he said.

The Fed needs to impose order on the application of Federal Reserve Act Section 13(3), which gives it the authority to lend to any individual, partnership, or corporation in “unusual and exigent circumstance,” Plosser said. “Clear objectives, a systematic approach, and transparency could improve policymaking and policy outcomes for our lending and credit facilities and reduce uncertainty and volatility in the marketplace,” he said.

The Federal Reserve can alleviate much of the uncertainty created by insolvent or failing institutions essential to the entire financial system by following the four principles above to establish clearer, more predictable procedures for dealing with such situations, Plosser said.

“Rather than trying to eliminate the risk of failure, the objective should be to reduce the systemic costs of failures, which would enable regulators to allow firms to fail when appropriate,” he said. “Once we arrive at a clear definition of systemic risk and agree that the goal is to reduce the costs imposed by systemically important institutions, we must then design policies to achieve that objective.”

Determining precisely which payment and settlement systems are systemically important and how to regulate them requires “careful consideration,” Plosser said. Further, suggestions that the Fed become the “macro-prudential overseer” of the stability of the entire financial system must be deliberated with “great care,” he said.

“Transparency is essential to improving financial stability,” Plosser said. “Standardization can also enhance financial stability by improving transparency.”

However, Plosser’s key concern in the Fed’s role in promoting financial stability is ensuring the Fed’s independence to conduct monetary policy, he said. The Fed should not take responsibility for funding or managing the resolution mechanism for failing institutions, nor should its lending policies stray into allocating credit across firms or sectors of the economy, Plosser said.

“The perception that the Federal Reserve is in the business of allocating credit is sure to generate pressure on the Fed from all sorts of interest groups,” he said. “In my view, if government must intervene in allocating credit, doing so should be the responsibility of the fiscal authority, rather than the central bank.”

Plosser’s talk helped second-year student Juan Guichard see the “big picture” in visualizing the problems created in the current crisis, Guichard said. “The message I got was that we should focus on the big, big points,” he said. “That will allow the participants in the system to have a correct set of incentives. In that sense, they will be prepared if this happens again and help avoid this happening again.”

                                                                                                                            — Phil Rockrohr