Once punch bowl-monitor, Fed now designated driver

WASHINGTON (Reuters) - Once, the Federal Reserve's job was to take away the punch bowl when the party got going.

Now, central bank policy-makers are acting like parents lecturing teenage children on the dangers of drinking and driving -- while making clear they are willing to provide a ride home at any hour to prevent a tragedy.

Until the collapse of U.S. housing market and the credit crisis that became full-blown in August last year, the Fed was known principally for setting interest rates to ensure steady growth with low inflation, raising rates when the economy turned a bit too festive and cutting them when growth was flagging.

While the institution supervises large bank holding companies, those functions took a back seat, in the public eye, to monetary policy and macroeconomic forecasting.

But as a global credit crisis and painful U.S. economic slowdown drag on, the Fed has interpreted its dual mandate on growth and prices to include responsibility to maintain the stability of the entire financial system -- an evolution that will mean more rules for financial institutions and an expanded caretaker function for the Fed.

That broader role -- which has led to closer ties with investment banks and a menu of options to ensure credit markets remain liquid -- has reshaped the central bank and will likely be subject to extensive scrutiny and debate for years to come.

SUPERVISORY ROLE

A rising tide of defaulting U.S. subprime mortgages, which undercut the value of assets held by financial institutions around the world, has thrust the central bank's regulatory authority, and its responsibility for financial stability, squarely into a not-always-flattering spotlight.

"What role could the Fed have played in 2006, 2007 from some regulatory standpoint in the financial system?" said Charles Calomiris, a Columbia University financial studies professor. "How about saying things like, 'Wait a minute, the assumptions underlying subprime securitization are completely wrong.'"

The central bank's interventions to broker the sale of failing investment bank Bear Stearns in March and to extend a financial lifeline to beleaguered mortgage giants Fannie Mae and Freddie Mac last month showed conclusively that the Fed would, on occasion, determine that some institutions were too big or too interconnected to be allowed to fail.

The Fed has faced criticism for shielding Wall Street from meltdown when many ordinary people were losing their homes through foreclosure. Others have worried the central bank could encourage heedless financial behavior in the future by providing a government safety net.

Fed officials say those risks point to a need for a bigger supervisory role.

"The existence of liquidity facilities at the central bank can undermine normal incentives for maintaining liquidity buffers, and the more extensive the access, the greater the degree to which market discipline will be loosened and prudential regulation will need to be tightened," Fed Vice Chairman Donald Kohn said on June 5.

LIQUIDITY TOOLS

Fed Chairman Ben Bernanke has argued that many investors have lost money despite government interventions and has said broader economic damage would have resulted if the authorities had not stepped in to avert even more intense credit strains.

The next president and Congress are expected to rewrite the book on financial regulation in 2009. They will have to wrestle with how to clarify the Fed's financial stability role generally, and its powers over investment banks specifically.

In the meantime, the Fed's broader reach is already being felt. It has teamed up with the Securities and Exchange Commission to oversee Wall Street firms, and has been given a consultative role in the supervision of Fannie Mae and Freddie Mac that includes providing input on capital standards.

Bernanke's Fed has also distinguished itself with its strategy of using specific tools to address specific problems, notably its focus on offering liquidity through a menu of options to ease credit strains.

The Fed chairman's academic background laid the groundwork for that creative problem-solving, said Jeffrey Frankel, an economics professor at Harvard University.

"Because his framework had to do with the Great Depression, had to do with channels outside money supply and interest rates, in this sense he was perfectly suited to do this," Frankel said.

BOLD MOVES

The year-old credit crunch also may have convinced the Fed its time-honored, incremental approach to adjusting interest rates does not always fit the circumstance. At times, fast-changing economic data or psychology may call for a rapid response and decisive measures.

The Fed was faulted last summer and again in December for being slow to react to a gathering or worsening financial storm.

In January, it started cutting rates aggressively, and a new sense of the effectiveness of easing quickly could translate to decisive rate hikes to quell price pressures if inflation or inflation expectations were to accelerate.

"It has worked so well that it does mean that should inflation suddenly jump out of the box, the door is open for the Fed to raise rates sharply at any given time," said Joseph Brusuelas, chief economist for Merk Mutual Funds.