Clarifying Central Bank Responsibilities for Monetary Policy, Credit Policy, and Financial Stability

Independence has long been recognized as an essential element of effective central banking. The extraordinary central bank interventions in the recent credit turmoil precipitated a reconsideration of the nature of that independence. On one side, the Federal Reserve has been commended for its willingness to provide generous support for the financial system in lieu of congressional support that was not always forthcoming. On the other side, the Federal Reserve has been condemned for its generous financial support for particular financial institutions, its critics calling for more scrutiny and oversight of Fed policy actions, and enhanced auditing of the Fed balance sheet. The Fed’s expansive initiatives put the central bank in a cross-fire and created a pressing need to clarify its independent responsibilities.

The extraordinary scale and scope of central bank initiatives in the credit turmoil exposed the weakness of insufficiently constrained central bank independence. Ambiguity about the boundary of independent responsibilities of the central bank has been shown to be counterproductive. Not only has the Fed put its own independence in jeopardy, but the lack of clarity on the boundary of its responsibilities helps to explain the failure of Congress to act sooner to provide fiscal support for the financial system. The boundary of the Fed’s independent 2 powers should be clarified to protect the central bank from being drawn into circumstances that compromise its independence in the future.

A central bank’s primary responsibility is to employ monetary policy independently to maintain macroeconomic and financial stability. The lesson from the recent credit turmoil is that to preserve independence on monetary policy, the fiscal policy powers of both monetary policy and credit policy must be clarified. This essay reviews the rationale for monetary policy independence. Then, it outlines the fiscal policy aspects of monetary policy and credit policy, and suggests a clarification of the boundary of responsibilities for each that can sustain central bank independence. The essay concludes by explaining why an independent central bank cannot serve as a “pinnacle financial stability oversight authority.”

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