Fed’s Plosser calls for rules for crisis-fighting measures

The Federal Reserve risks losing its credibility and exacerbating moral hazard unless it adopts a rules-based approach to its exceptional monetary policy measures, Charles Plosser, the president of the Philadelphia Federal Reserve Bank, said on Friday.

"Central bank independence is no guarantee that time-inconsistency problems that are inherent in monetary policymaking will be mitigated without explicit rules and constraints," Plosser said in Zurich. "Having the ability to make credible commitments that constrain current and future policymakers to conduct systematic policy and limit discretionary behavior yields better economic outcomes over the long run."

Balance sheet

Plosser said the Fed's use of innovative policy tools, which have at times involved the expansion of its balance sheet and purchases of assets other than Treasuries, made it "increasingly difficult for them to credibly commit to a particular policy course."

"Market participants now see such lending as more likely and will be tempted to urge the Fed to use the authority again," he said. "The use of such discretionary tools without some form of credible commitment that defines and limits their use in the future can and will distort private incentives, creating moral hazard that will cause problems in the future, and undermining the credibility of the Fed."

Plosser noted that, in terms of creating a rules-based approach to innovative policymaking, the Dodd-Frank Act's limits on section 13(3) - the section of the Federal Reserve Act that enables the Fed to lend directly to "corporations, partnerships and individuals" under "unusual and exigent circumstances" and thereby paved the way for large-scale asset purchases - were "good first steps".

A "slightly stronger step" would be for the Fed's board to pledge not to use the powers available under section 13 (3) "without obtaining prior public support from the Congressional leadership along with the Treasury."

A stronger constraint still would be for the Fed to refrain from lending of this sort "unless it was requested to do so by the Treasury and Congress."

"In each of these options, discretion on the part of the Fed becomes increasingly constrained. Yet, discretion is shifted to the Treasury and Congress, which is arguably where it should be, since such lending in a financial crisis is a form of fiscal policy," he said.

In terms of the purchases of assets other than Treasuries, Plosser advocated the development of guidelines for when the Federal Open Market Committee might wish to undertake such purchases or a Treasuries-only policy, an idea favoured by Richmond Fed president Jeffrey Lacker.

Interest on reserves

Plosser further noted that the Fed's opting to pay interest on reserves since October 2008 could come at the cost of central bank independence. "Many overlook that paying interest on reserves ties together the central bank's balance sheet and the government's budget constraint," he said.

Friday's comments are the latest in a series of attacks by Plosser on the Fed's crisis response.