Central banks' role as finance police 'to backfire'

Major central banks are taking on a new role of finance police in the wake of the global financial crisis but they could find their hands more tied as a result.

The US Federal Reserve and the European Central Bank are set to take a central stake in financial regulation under reforms currently before legislators, while Britain's opposition Conservative Party has similar plans for the Bank of England.

The plans are part of a global push to develop better weapons against financial market excesses, which many blame for the financial crisis, but critics say the plans may backfire.

Some fear that widening central bank responsibilities for the financial sector risks clouding their focus on inflation and opening them to external lobbying to keep interest rates low – potentially fuelling inflation and a fresh bout of risk-taking. Central banks charged with preserving both price stability and financial stability may find conflicting signals complicate an argument to raise rates. The new powers may also bring more interference from politicians keen to have a say in how banks are treated, as well as pressure from banks themselves.

"There's a real tension between central bank independence and fulfilling a much more political task like regulating and supervising banks," said Citigroup chief economist Willem Buiter, a former Bank of England policymaker. "Central banks should not be in charge of financial stability. That's the job of fiscal authorities."

Politicians, however, seem to disagree.

The Fed already has a formal mandate to supervise banking operations and proposed reforms would make it the crux of a new body overseeing systemic risk, with the power to break up complex firms.

In a similar vein, the ECB, which currently has no direct role in supervision, is set to chair a new European Systemic Risks Board, taking a big-picture view of risks developing in the financial sector.

And in the UK, the Conservatives, if they are elected, plan to centralise financial regulation at the BoE, scrapping the Labour government's system of shared responsibility between the central bank, Treasury and Financial Services Authority.

The proposed changes may mean central bankers' focus on price stability becomes fuzzier as other influences crowd in, setting the stage for higher inflation.

At the Fed, new powers may be accompanied by less freedom as Washington could gain greater influence over appointing Fed officials, and Congress could be able to second-guess monetary policy decisions.

Eugene Ludwig, chief executive of Washington-based Promontory Financial Group and a former head of regulatory agency Office of the Comptroller of the Currency, said more power naturally attracted more attention. "The more authority the Fed gathers, the more its role is politicised. As the Fed's role expands, it's almost inevitable that policymakers will want some controls over it because its influence in the economy is so enormous," he said.

Fed officials say congressional reviews of rate decisions would likely increase long-term borrowing costs as markets surmise politicians could press the Fed to hold short-term interest rates too low for too long and ignite inflation.

Under other proposed changes, the US president would appoint the New York Federal Reserve Bank president, who always votes on the Fed's policy-setting body and is the key liaison to Wall Street.

Making the New York Fed president a political appointee would link the office more closely with a political administration and could increase market perception of greater sympathy to holding rates low to boost employment and the economy, putting price stability in the background.

Although increased political scrutiny is – so far – lacking from the proposed UK and EU reforms, some worry they will still cramp central bank autonomy.

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