Expanded Fed role may weigh on monetary tasks

WASHINGTON (Reuters) - Granting the Federal Reserve extensive new powers in a sweeping overhaul of financial regulation might hamper its ability to craft monetary policy that would steer the economy and fight inflation.

Under President Barack Obama's plan, the Fed's Board of Governors would be responsible for policing large financial companies whose failure could destabilize the economy.

The administration's plan aims to fix flaws that allowed risky practices to escape scrutiny and resulted in the collapse of companies such as investment banks Bear Stearns and Lehman Brothers and insurer American International Group last year.

Those debacles led to a global financial crisis that has thrown economies around the world into deep recessions.

Yet expanding the Fed's regulatory authority on top of the central bank's already complicated role of ensuring stable prices, low unemployment, and acting as lender of last resort may stretch its capacity.

"That is a big set of responsibilities," said former Fed Vice Chairwoman Alice Rivlin. "That's enough. I would not give them a major regulatory responsibility."

Other former Fed officials also worry that placing this burden on the central bank might be a distraction, at best, and could weaken the quality of its monetary policy decisions.

"Performing this function may get in the way of the Fed performing its fundamental function of ... preventing inflation and preventing deflation," said former Richmond Federal Reserve Bank President Alfred Broaddus.

"People are already worried that the things the Fed has had to do to fix this problem are going to lead to ... inflation outcomes down the road," he said.

However, Fed officials do not see the Treasury proposal as a radical change in their powers that would blur their focus, or something that would erode the Fed's ability to conduct monetary policy independently.

The Fed's expanded role in supervising systemic risk is likely to require some imaginative thinking about how to regulate major firms from the perspective of the safety and soundness of the broad system, but would not be a major departure from current powers or responsibilities the Fed has in its current role, senior officials feel.

Treasury Secretary Timothy Geithner explicitly dismissed suggestions during congressional testimony that the proposed plan could clip the Fed's policy wings.

"We are very committed, and it is very important, that we preserve the independence of the Fed, and (the) basic credibility of its responsibilities for monetary policy," Geithner told the Senate Banking Committee on Thursday. "If we lose that credibility, that would be very damaging."

PRIOR APPROVAL

Normally, the Fed is only allowed to lend money to highly regulated deposit-taking banks.

However, using emergency powers which allow it to lend to a wider array of institutions in "unusual and exigent circumstances," it has deployed tens of billions of dollars to rescue Bear Stearns and AIG in the midst of the financial crisis, to the chagrin of some lawmakers who feel it has strayed from its monetary policy mission.

Critics feel this verges on fiscal policy because it is an act of credit-allocation which chooses winners and losers.

In addition, the assets taken on to the Fed's balance sheet as collateral for these loans have been of lower credit quality than it would normally accept. This could make it harder for the Fed to sell them when it wants to shrink its balance sheet, as it will have to do to limit money supply growth when growth picks up steam, in order to keep inflation pressures at bay.

Under Obama's plan, the Fed would need prior written authority from the Treasury if it wants to use those emergency powers in the future.

Obama administration officials acknowledged that the Fed's emergency actions put taxpayer funds on the line without the same sort of accountability that elected officials have.

"Lending to an institution you don't supervise in a circumstance of risk is an inherently political act," White House economic advisor Lawrence Summers said on Wednesday.

"For the Fed to engage in that act solely on its own accountability would be to become more engaged in politics," he said, adding Fed Chairman Ben Bernanke supported the proposal.

Fed officials do not see the emergency reporting requirement or a report on Fed system structure as presenting any risks to independence. The Fed used its emergency powers as a last resort to prevent failures of systemically important firms, and strong new resolution authority should make the kind of intervention unnecessary in the future, they believe.

In addition, Fed consultation with Treasury during the crisis was close and appropriate, and was entirely separate from monetary policy decisions, officials said.

CODE WORD

The plan also calls on the Fed to review the governance and accountability of its 12 regional banks by October 1, and calls on the Treasury to consider the Fed's recommendations and propose any changes appropriate to improve Fed "accountability."

"It could mean anything," said Ken Kuttner, a professor of economics at Williams College in Williamstown, Massachusetts. "It could be a code word for the kind of thing that Barney Frank has been talking about."

Frank, a Democrat from Massachusetts and chairman of the powerful U.S. House of Representatives Financial Services Committee, has suggested the appointment of the 12 regional Fed presidents should be subject to congressional approval.

At present the 12 regional chiefs are picked by local business leaders in their districts, subject to the blessing of the Fed Board in Washington.

However, Fed officials said the report on Fed structure could be seen as a review of whether Fed powers align with new roles under the regulatory overhaul proposal.

Analysts warned a shake-up could weaken monetary policy if it marginalized the input of the regional banks.

Broaddus, who spent 34 years at the Fed, said the regional banks had played a big role in some of the most politically controversial decisions, such as the big interest rate increases that defeated U.S. inflation in the 1980s.

"There were some crucial points at which the reserve bank presidents exerted pressure," he said. "I always felt that I was not accountable to anyone apart from the public interest."

(Reporting by Alister Bull and Mark Felsenthal, editing by )