Moment of crisis could test Fed's independence

NEW YORK (Reuters) - The Federal Reserve’s close coordination with the Bush administration on extraordinary measures to settle a credit market in crisis, while needed in the short-term, could pose a challenge to the U.S. central bank’s independence in the long run.

“The hard fact of life is that when it comes to emergency rescue operations the central bank and Treasury need to lock arms, and they did,” said Alan Blinder, economics professor at Princeton and a former Fed vice chairman. “The hard part is going to be, as the emergency lifts, to unlock the arms.”

Blinder argues Fed Chairman Ben Bernanke has done a good job of engaging himself in the broad strokes of policy -- such as his suggestion of further fiscal stimulus at a time when the Fed is running out of ammunition -- while withdrawing from the nitty gritty battles that must take place at the legislative level.

The central bank has already slashed interest rates sharply in the past year, yanking them from 5.25 percent last September down to the current 1.5 percent, with very limited success in unclogging the credit markets. Many analysts expect yet another half percentage point rate cut at a Fed meeting scheduled for next week.

Against this backdrop, it is not difficult to see why Bernanke would offer Congress advice on fiscal policy, as he did earlier this week in calling for further measures to spur the economy.

“If the Fed does nothing here and the economy goes into a tailspin and we go into a very deep dire recession, there are going to be calls for Bernanke’s scalp,” said Michael Feroli, economist at JPMorgan.


But the closer Fed leans into the political arena, the greater the risk of deleterious effects on the central bank’s public image as an insulated, independent organ.

Concerns have been raised about the exceptionally close cooperation between the Treasury and Fed as they jointly pushed for a $700 billion financial rescue package, an episode that featured a number of public appearances at which Bernanke appeared at Treasury Secretary Henry Paulson’s side.

During a recent speech in New York, Philadelphia Federal Reserve Bank President Charles Plosser was pressed on the issue by Benn Steil, a senior fellow and director of international economics at the Council on Foreign Relations.

Steil noted that a couple of months back, a U.S. congresswoman had become the butt of some jokes for having mistaken Bernanke for Paulson.

Today, he added, she might be forgiven for the error.

“Their roles seem to have been blurred quite significantly,” he remarked.

Economists agree close links with the Treasury are needed for the moment, but they say the Fed should also be actively thinking about how it will eventually pull away.

One source of anxiety is the experience of the 1970s. At that time, then-Fed Chairman Arthur Burns was seen as closely allied with the Nixon administration, and therefore reluctant to raise interest rates -- and potentially choke growth -- in the face of roaring inflation.

Burns is therefore thought to have contributed to the period of soaring prices that plagued the country for a decade, until inflation hawk Paul Volcker helped tame those price rises with an extraordinarily tight monetary policy.

For now, however, analysts say Bernanke has made compromises that needed to be made, and they remain hopeful he will avoid falling under the undue influence of a given administration.

“The Fed has become party to a host of arrangements and actions it would not have touched with a barge pole under less extreme and hazardous circumstances,” said Willem Buiter, professor at the London School of Economics and former Bank of England member. “Such a triumph of the urgent over the important but not so urgent appears to be unavoidable when it comes to actual policy-making.”

Reporting by Pedro Nicolaci da Costa, Editing by Chizu Nomiyama