Expansion of Fed's role spurs fears of overreach

BEN BERNANKE is still trying to define which financial institutions it's safe to let fail. The longer it takes him to decide, the tougher the decision becomes.

In the year since credit markets seized up, the 54-year- old Federal Reserve chairman has repeatedly expanded the central bank's protective role, turning its balance sheet into a parking lot for Wall Street's hard-to-finance bonds and offering loans through its discount window to investment banks and mortgage firms Fannie Mae and Freddie Mac.

The lack of clearly defined limits may put the Fed's independence at risk as Congress discovers that its $900 billion portfolio can be used for emergency bailouts that might otherwise require politically sensitive appropriations and taxes.

"There is some hard thinking that needs to be done," Philadelphia Federal Reserve Bank president Charles Plosser said in an interview last week. "The Fed has a terrific reputation as a credible institution. We have to be cautious not to undertake things that put that credibility at risk." The expanding role of central banks will be the hottest topic when Mr Bernanke addresses his counterparts from around the world at the Kansas City Fed's Wyoming, symposium this Friday.

Since taking on $29 billion in Bear Stearns assets to facilitate the failing firm's takeover by JPMorgan Chase, Mr Bernanke has made several moves that imply further expansion of the central bank's mission.

He granted a congressional request to accept bonds backed by student loans as collateral for Fed securities loans. And he didn't object when Congress inserted a provision into the housing bill that makes it easier for the Fed to lend to failed banks under government control.

"They want to placate the Congress and the financial markets," says Fed historian Allan Meltzer; doing so sets a "terrible precedent".

Policy makers are aware of the concern. The Federal Open Market Committee has ordered a formal study of the implications of the Fed's broader role in fostering financial stability.

Under Mr Bernanke's predecessor Alan Greenspan, the Fed drew a clear line against using its portfolio to influence specific markets.

Officials "are overburdening the Federal Reserve, and that sets up the potential for multiple conflicts" says Vincent Reinhart, former director of the Fed's monetary affairs division, who advised both Mr Bernanke and Mr Greenspan. "They use up their credibility on non-monetary issues, they lose their independence and they dilute their expertise."

Mr Reinhart, now a resident scholar at the American Enterprise Institute in Washington, is one of several Fed alumni who say they are concerned the central bank will next face requests to rescue hedge funds or insurance companies whose failure might damage the financial system.

"It is much harder to say no when you have the precedent," says J Alfred Broaddus jnr, former president of the Richmond Fed.

The Fed chairman's decisions are a decisive break with Greenspans aversion to government interference in markets, a conviction that even permeated the central banks day-to-day operations.

To Mr Bernanke, the decisions of the past 12 months may well have protected the Fed's independence from far greater erosion that might have occurred if the central bank had stood aloof while financial markets melted down.

The former Princeton University scholar views the Great Depression as a fiasco that compromised the Fed's credibility, bringing an onslaught of regulation and a congressional review of the Federal Reserve Act. If the Fed had walked away from Bear Stearns, it would have led to higher unemployment, a deeper downturn and a longer recovery, all of which would have brought even greater political pressure on the Fed, the chairman's defenders argue.

"It is not an easy sell," Mr Bernanke told senator Evan Bayh, an Indiana Democrat, during an April 3rd hearing on the Bear Stearns rescue. "But the truth is that the beneficiaries of our actions were not Bear Stearns and were not even principally Wall Street. It was Main Street."

- (Bloomberg)