FT: Treasury proposes new powers for Fed

April 30, 2008

This article isn’t long on details. Treasury feels “enhanced regulatory powers” would be a “better tool than interest rates” to “contain asset price bubbles.”

Hmmm. The Fed isn’t currently charged with the task of containing asset bubbles to begin with. Its job is to maintain low inflation consistent with full employment. The prevailing view of the Fed’s role vis-a-vis asset bubbles during the Greenspan years was summed up by the man himself in 2004:

It is far from obvious that bubbles, even if identified early, can be pre-empted at a lower cost than a substantial economic contraction and possible financial destabilization,” Greenspan told the American Economic Association in 2004.

The Fed has been rethinking this view of late.

I’m particularly curious about the part that mentions the Fed using its authority to order hedge funds to “curtail strategies” that put the wider economy at risk. How would the Fed do that? Hedge funds are ostensibly unregulated now. Would HFs report real-time data to the Fed on their positions and trades? The Fed would need to build a rather large bureaucracy to be an effective chaperon.

The Federal Reserve could use proposed new regulatory powers to try to stop credit and asset market excesses from reaching the point where they threaten economic stability, the US Treasury said on Tuesday.

David Nason, assistant secretary for financial institutions, said the Fed could even use its proposed “macro-prudential” authority to order banks, hedge funds and other entities to curtail strategies that put financial stability at risk.

By “leaning against the wind” in this way, the US central bank could “attempt to prevent broad economic dislocations caused by potential excesses”, he said.

His comments come amid debate inside the Fed as to whether it should try to do more to contain asset price bubbles, following the housing and dotcom busts. Some see enhanced regulatory powers as a better tool for this than interest rates.

The proposed new powers – outlined in a Treasury blueprint published last month – require legislation and may never be authorised. But policymakers see the plan as offering a template for future regulation.

The blueprint envisages giving the Fed roving authority to collect, analyse and publish market data from a wide range of institutions, from banks to hedge funds.

“The market stability regulator must have access to detailed information about all types of financial institutions,” said Mr Nason.

Hedge funds are uneasy about this proposal. However, many European central bankers are eager to acquire the kind of macro-prudential powers the Treasury would like to give to the Fed.

Meanwhile, data showed accelerating US house price declines and further declines in consumer confidence.

Incidentally, the WSJ published a fascinating op-ed today that argued the Fed should rethink its mandate. Since Phillps theorized his curve, it has been thought that there is a tradeoff between inflation and employment. Too low inflation reduces economic activity, lowering employment. But the author argues that the data don’t confirm this relationship, that low inflation years and the periods thereafter are marked by higher employment. With this in mind, he argues the Fed should start raising rates again not only to protect the dollar but to promote long-term growth.

That would boost the returns on my money market investments, so I’m supportive. Not to mention that a stronger dollar would bring oil and food prices back to earth….


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Don’t forget property tax, which is quite a bit more for a home that is selling for twice the dollar amount, regardless of the mortgage interest rate.By the way, I understand that escrow, the putting aside of money for property tax, was also lost in the shuffle to sell homes in the big run-up.

Posted by Clif | Report as abusive

Interest rates will continue to fall until they approach 0%, then stay there for decades. This is the lesson of modern Japan and the USA’s 1930s. During times like these, home prices almost always fall until they approach the typical cash payment portion of their peak price, for us that is about 10% to 20% cash down, which indicates a fall of about 85% from peak price.

Posted by Jimbo | Report as abusive

You’re right, the third point is the key. Rates will remain low only so long as we can keep exporting our debt. Whether Treasuries, agencies, or corporates, foreigners aren’t buying them like they were, though. The money spigot is being cranked shut.

Posted by Knute Rife | Report as abusive

Knute: That’s the problem with Jimbo’s argument it seems to me (though I confess I don’t understand his math): what happens if we’re headed for a Japan style deflationary bust? One that forces the Fed to drop interest rates to zero?The difference with Japan is that they had a very large balance of payments surplus. Keeping interest rates low in the U.S., where we have a large trade deficit, is much more reliant on foreigners’ willingness to buy our debt at low interest rates. They probably won’t go along. Interest rates head back up and home prices resume their decent.

Posted by RW | Report as abusive