REFILE-Reform should exploit policy, supervision link -study

(Fixes dateline)

CHATHAM, Mass.,, Oct 22 (Reuters) - Regulatory reform should make use of the key link between supervision, financial stability and monetary policy, according to a paper co-authored by Boston Federal Reserve president Eric Rosengren.

The recession would have been much worse if the Fed had not had the hands-on experience with financial institutions and markets required to step in and fight the crisis, Rosengren, University of Kentucky's Joe Peek and the Boston Fed's Geoffrey Tootell wrote.

"Whatever regulatory reform is adopted, it should exploit the synergies between monetary policy, supervisory policy, and policies to promote financial stability," the authors wrote.

The paper, presented Thursday, was prepared for the Boston Fed's annual conference in Cape Cod, which this year is focused on regulation and supervision after the crisis.

The Obama administration has proposed wide-ranging changes to the U.S. regulatory landscape in the hope of preventing a recurrence of the credit crisis that pushed the U.S. financial system to the brink of collapse last year.

One of the administration's proposals is creating an inter-agency council of regulators to oversee risks to the economy from large, interconnected firms, with the Federal Reserve and Treasury Department in key roles.

The administration had wanted to give the Fed a dominant position as systemic risk regulator, but that stance has softened in the face of widespread lawmaker skepticism.

The paper argues that because financial crises can lead to more severe economic downturns, it is key for the Fed to understand the problems experienced by financial intermediaries -- firms that act as middle-men between those who want to lend and those who want to borrow -- and the risks that banking problems spill over into the broader economy.

The paper notes that during the most recent crisis the Federal Reserve's policy-setting Federal Open Market Committee (FOMC) started cutting the benchmark federal funds rate in August 2007 even though the recession hadn't begun and many private forecasters were "seeing little evidence the economy was faltering".

And when the Fed began aggressively cutting interest rates in December 2007, forecasts for the unemployment rate still did not justify their decision, the authors said.

"Simple rules", such as the oft-cited Taylor rule, miss "the usefulness of the nexus between monetary policy, supervisory policy, and financial stability," the authors wrote.

"Given that the forecasts for inflation and unemployment were not significantly different from their long-run targets at the onset of this recession, these simple rules failed to capture FOMC behavior at the time," they wrote.

"Because forecasting is so inexact, the FOMC often supplements these forecasts with other information," they added.

As well as supervisory and financial stability information helping inform monetary policy,"supervisory policy and programs to promote financial stability are likely to be improved when integrated with monetary policy," they wrote.

An example for this, they said, were the so-called "stress tests" conducted earlier this year on the 19 largest financial institutions.

(Reporting by Kristina Cooke, Editing by Chizu Nomiyama)