ANALYSIS-Central banks’ police job may cloud monetary tasks

April 26, 2010

  By Krista Hughes and Mark Felsenthal
   FRANKFURT/WASHINGTON, April 26 (Reuters) – Major central banks are taking on a new role of finance police in the wake of the global financial crisis but they could find their hands more tied as a result.
   The U.S. Federal Reserve and the European Central Bank are set to take a central stake in financial regulation under reforms currently before legislators, while Britain’s opposition Conservative Party has similar plans for the Bank of England.
   The plans are part of a global push to develop better weapons against financial market excesses, which many blame for the financial crisis, but critics say the plans may backfire.
   Some fear that widening central bank responsibilities for the financial sector risks clouding their focus on inflation and opening them to external lobbying to keep interest rates low — potentially fuelling inflation and a fresh bout of risk-taking.
   Central banks charged with preserving both price stability and financial stability may find conflicting signals complicate an argument to raise rates. The new powers may also bring more interference from politicians keen to have a say in how banks are treated, as well as pressure from banks themselves.
   “There’s a real tension between central bank independence and fulfilling a much more political task like regulating and supervising banks,” said Citigroup chief economist Willem Buiter, a former Bank of England policymaker.
   “Central banks should not be in charge of financial stability. That’s the job of fiscal authorities.”
   Politicians, however, seem to disagree. The Fed already has a formal mandate to supervise banking operations and proposed reforms would make it the crux of a new body overseeing systemic risk, with the power to break up complex firms. [ID:nN15206128]
   In a similar vein, the ECB, which currently has no direct role in supervision, is set to chair a new European Systemic Risks Board, taking a big-picture view of risks developing in the financial sector. [ID:nGEE5B01MK]
  And in the UK, the Conservatives, if they are elected, plan to centralise financial regulation at the BoE, scrapping the Labour government’s system of shared responsibility between the central bank, Treasury and Financial Services Authority. [ID:nLDE63B0T5]
   PRICE STABILITY IN THE BACKSEAT?
   The proposed changes may mean central bankers’ focus on price stability becomes fuzzier as other influences crowd in, setting the stage for higher inflation.
   At the Fed, new powers may be accompanied by less freedom as Washington could gain greater influence over appointing Fed officials, and Congress could be able to second-guess monetary policy decisions.
   Eugene Ludwig, chief executive of Washington-based Promontory Financial Group and a former head of regulatory agency Office of the Comptroller of the Currency, said more power naturally attracted more attention.
   “The more authority the Fed gathers, the more its role is politicized. As the Fed’s role expands, it’s almost inevitable that policymakers will want some controls over it because its influence in the economy is so enormous,” he said.
   Fed officials say congressional reviews of rate decisions would likely increase long-term borrowing costs as markets surmise politicians could press the Fed to hold short-term interest rates too low for too long and ignite inflation.
   Under other proposed changes, the U.S. president would appoint the New York Federal Reserve Bank president, who always votes on the Fed’s policy-setting body and is the key liaison to Wall Street.
   Making the New York Fed president a political appointee would link the office more closely with a political administration and could increase market perception of greater sympathy to holding rates low to boost employment and the economy, putting price stability in the background.
   Although increased political scrutiny is — so far — lacking from the proposed UK and EU reforms, some worry they will still cramp central bank autonomy.
   Sylvester Eijffinger, professor at the Netherlands’ Tilburg University, said responsibility for financial stability made a central bank vulnerable to pressure from the financial sector.
   “It becomes harder for the central bank to act independently, not because of political interference, but because of lobbying by the financial industry and a need to accommodate their problems,” he said.
   “The ECB has never been confronted with this problem but other central banks have … and practice shows that the objective of financial stability prevails.”
   Policymakers charged with preserving financial as well as price stability can face conflicting impulses in setting interest rates, even if they wield separate regulatory tools.
   ECB policymakers are so far insisting they will set rates only on the outlook for inflation, but academics say it is unrealistic to quarantine information a central bank gathers with its “systemic risks” hat on from its rate decisions.
   A similar dilemma could emerge at the BoE — although not necessarily a bad thing.
   “There will be more tradeoffs: perhaps we should tighten now, but the banking system is very fragile,” said Stefan Gerlach from Frankfurt University’s Institute for Monetary and Financial Stability.
   “Incorporating these macroprudential issues into setting monetary policy involves a recognition of how difficult these decisions are given all the factors which have to be taken into account. Just setting inflation at 2 percent — there’s more to central banking than that.” (Editing by Neil Stempleman) ((krista.hughes@reuters.com; +49 69 7565 1313; Reuters Messaging: krista.hughes.reuters.com@reuters.net))
 Keywords: FINANCIAL CENBANK/REGULATOR 
  
Monday, 26 April 2010 09:09:31RTRS [nLDE63D15L] {C}ENDS

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