Introduction

The role of the U.S. Federal Reserve has come under increasing scrutiny in the wake of the 2007-2009 global financial crisis. Former Fed chairman Alan Greenspan's policy of holding interest rates down for an extended period of time in the early 2000s is thought by many economists to have fueled the housing bubble that contributed to the crisis. Greenspan rejects the notion that the Fed is responsible for what, he argues, was a global housing bubble (CNN). Either way, the Fed's large-scale interventions into the financial system during the height of the crisis have triggered a debate over the U.S. central bank's regulatory authority.

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The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act sought to address the evolving role of the Fed in the post-crisis period. Dodd-Frank granted the Fed new powers to break up large companies threatening economic stability. But it also subjected monetary policy to audits by Congress and the newly created Consumer Financial Protection Agency. Still, debate over the Fed's role continued after it enacted two rounds of quantitative easing--the buying of U.S. Treasury bonds--to help spur economic growth. The Fed has bought over $2 trillion worth of government bonds since the end of 2008. Partisan gridlock in Washington--limiting the government's ability to respond to the economic downturn--has forced the Fed to take on a greater policy role to battle the country's economic malaise.

The Fed's Dual Mandate

Following a series of financial panics and banking runs, Congress passed--and President Woodrow Wilson signed into law--the 1913 Federal Reserve Act. The law created the Federal Reserve System, comprising twelve public-private regional federal reserve banks. Today, the Fed is tasked with managing U.S. monetary policy, regulating bank holding companies and other member banks, and monitoring systemic risk. The seat of power of the central bank is situated in the Washington, DC-based seven member Board of Governors, currently headed by Chairman Ben Bernanke. Each member is appointed by the president and subject to confirmation by the Senate. The members of the Board of Governors are part of a larger board that includes five of the regional bank presidents, known as the Federal Open Market Committee (FOMC). The FOMC is responsible for making decisions on open market operations, including determining interest rates and purchasing U.S. treasuries.

Historically, the Fed's monetary policy was governed by a "dual mandate" to maintain stable prices and full employment. The Fed's main method for achieving those goals has been to vary its fed funds target by altering its purchases and sales of U.S. treasuries and federal agency securities. The current benchmark by which many economists judge the aptness of Fed policy is the so-called Taylor's rule. Developed by Stanford economist John Taylor, the formula stipulates that interest rates should be raised when inflation or employment rates are high, and lowered under the opposite conditions.

The Gramm-Leach-Bliley Act of 1999 legalized the merger of securities, insurance, and banking institutions--essentially allowing for the joining of retail and investment banking operations--that were formerly separated under the 1933 Glass-Steagall Banking Act. It also gave the Fed the authority to determine appropriate financial activities within bank holding companies and member banks. The law made the Fed responsible for ensuring banks' soundness by enforcing regulations such as minimum capital requirements, banking consumer protections, anti-trust laws, and prevention of money laundering.

Dodd-Frank: A New Mandate

The recent global financial crisis was triggered in large part by the actions of an undercapitalized banking system that took excessive risk. The Dodd-Frank Act grew out of a need to "address this increasing propensity of the financial sector to put the entire system at risk and eventually to be bailed out at taxpayer expense," said a 2011 report by New York University's Stern School of Business.

Dodd-Frank instituted a third official mandate for the Fed, empowering it to regulate systemic risk and preserve financial stability. The Fed is now required to present its findings on risky, non-bank financial firms to the Financial Stability Oversight Council, which instructs the Fed on how to sanction those institutions.

"The Fed has a great deal more responsibility," says Professor Thomas Cooley of New York University's Stern School of Business. "It is the primary watchdog for identifying systemically risky instiutitons of all types, including shadow banking institutions [such as hedge funds]," he explains. Moreover, Cooley says, the law "requires a greater degree of transparency in terms of how the Fed is lending money."

Meanwhile, Professor Darrell Duffie of Stanford University thinks that Dodd-Frank is a "step forward" for financial stability, but does not go far enough. Regulating authority, Duffie argues, should be more centralized in the Fed. "It should be the same agency writing the check [to bail out a given financial institution] that is responsible for oversight," Duffie says, referring to the central bank's role as a "lender of last resort."

Holes in the System: Origins of "Systemic Risk"

Experts have sought to identify the key drivers of so-called "systemic risk," or the financial interdependencies that allowed a seemingly limited subprime mortgage crisis to culminate in widespread panic in the United States and abroad, as well as the failure of some of the country's most prominent financial institutions. Some critics of Fed policy consider its actions from 2003 to early 2005 at least partially to blame. During this period, the Fed, under the direction of then-chairman Alan Greenspan, kept the federal funds rate at 1 percent and allowed for significant credit expansion.

In the 2009 book The Road Ahead for the Fed, Carnegie Mellon's Allan Meltzer writes that, judging by the Taylor's rule guidelines on setting interest rates, Greenspan's Fed policy was too expansive, considering that short-term interest rates remained negative as the economy continued to grow. Greenspan attributed this policy to his belief that the U.S. economy faced a risk of deflation (a decline in prices due to a tightening supply of credit) similar to Japan's experience in the 1990s.

Other experts point to the 1999 repeal of the Glass-Steagall Act--which led to an escalation in the number of non-bank institutions responsible for issuing credit--as a catalyst for increased systemic risk. The share of credit extended by banks in the United States dropped from 60 percent half a century ago to 20 percent in 2009. Mauro Guillén, professor of management at University of Pennsylvania's Wharton School of Business, says the repeal of Glass-Steagall was part of a regulatory "race to the bottom" between Britain and the United States in the 1980s and 1990s as they competed to woo financial firms.

Federal Reserve Chairman Ben Bernanke has also cited lax government regulation and gaps in oversight as causes of the crisis. In a March 2009 speech at the Council on Foreign Relations, Bernanke said, "The risk-management systems of the private sector and government oversight of the financial sector in the United States and some other industrial countries failed to ensure that the inrush of capital was prudently invested, a failure that has led to a powerful reversal in investor sentiment and a seizing up of credit markets."

Competing Objectives

Now that the Fed has been charged with overseeing systemic risk, experts question how it can best respond to systemic threats while fulfilling its original "dual mandate." Some argue that managing monetary policy and systemic risk presents the Fed with a conflict that could ultimately undermine price stability.

Professor Charles Calomiris of the Columbia University Graduate School of Business says to successfully implement these varying objectives, monetary policy (the "dual mandate") must be kept separate from macroprudential regulation (maintaining financial stability). Dodd-Frank, Calomiris argues, does not do enough to outline rules to this end. "It doesn't provide any guidelines for what macroprudential regulation is," he says. The law is "sympathetic" to the creation of a macroprudential authority, but not "specific."

Stanford's Duffie says the additional Fed mandate has made the central bank not just the "lender of last resort," but an "asset manager of last resort." In short, Duffie explains, the mandate of financial stability means the Fed wants to ensure that it does not lose a lot of money, whether or not it is in the best interest of monetary stability. But, Duffie argues, this conflict of interest is "outweighed by the benefits of coordinated responsibility."

Moreover, while Cooley agrees that the Fed has a "big additional role" in terms of its financial stability mandate, he says that even with just the dual mandate, it has been forced to balance competing objectives in a way that other central banks do not. For example the European Central Bank has only one mandate, which is to maintain price stability. As such, Cooley says, that bank is more aggressive at raising interest rates. The Fed has long been unique as a central bank because the United States holds the world's reserve currency. "It can provide other countries access to dollar deposits. It has a leadership role," Cooley says.

Quantitative Easing

Some of the fiercest criticism of the Fed came after its November 2010 announcement that it would buy $600 billion (BBC) in long-term Treasury bonds to stimulate a struggling economy. The Fed hoped that a second round of so-called quantitative easing, or QE2--the first was implemented at the end of 2008 during the height of the crisis--would lower long-term interest rates, raise stock prices, and boost job growth. Twenty-three conservative economists wrote a letter to the Fed criticizing the plan for potentially stoking inflationary pressures, weakening the dollar, and failing to alter the jobless rate. QE2 wrapped up in June 2011. But following the S&P downgrade of U.S. debt in early August, subsequent global market volatility, and fears of another recession, many investors have looked to the Fed to implement a third round of bond buying in the absence of any coherent fiscal policy by legislators.

The concept behind quantitative easing is to create more resources for the financial system, making banks freer to lend and the public more apt to borrow, says NYU's Cooley. The problem, he says, is that there is not enough demand to borrow. The Fed should continue to hold interest rates down, Cooley maintains, but additional rounds of QE won't help the economy. "Monetary policy can't solve economic problems." Nor, he says, reflecting the view of a number of economists, can it facilitate innovation or generate growth.

Bernanke shied away from a third round of quantitative easing, but promised August 9, 2011, that the Fed will keep interest rates near zero (Reuters) at least through 2013. The decision underscored growing tensions within the FOMC: For the first time in eighteen years, three regional bank presidents dissented.

The three presidents--Richard Fisher of Dallas, Narayana Kocherlakota of Minneapolis, and Charles Plosser of Philadelphia--again dissented September 21 when the Fed announced a new take on quantitative easing, known as "Operation Twist." The Fed said it would sell $400 billion (CNN) in short-term treasuries in exchange for longer-term bonds. The move was part of a continued push to keep long-term interest rates down and generate borrowing.

In June 2012, the Fed announced an extension of "Operation Twist" (WSJ) through the end of the year, a policy measure supported by eleven out of twelve FOMC officials. In September of that year, amid continuing concerns over the high unemployment rate, the Fed announced a new round of quantitative easing (WSJ). The Bank's policymaking committee said it would buy $40 billion of mortgage-backed securities per month on an open-ended basis, while vowing to "undertake additional asset purchases, and employ its other policy tools as appropriate" until the labor market improves. At the same time, the Fed committed to extending "Operation Twist"--bringing its total purchases of long-term bonds to $85 billion a month through the end of the year--and keeping short-term interest rates near zero through mid-2015. Eleven out of twelve FOMC officials supported the monetary action. In December 2012, the Fed reinforced these policy steps (WashPost) by vowing to hold short-term interest rates near zero until the unemployment rate--at 7.7 percent as of November 2012--falls below 6.5 percent, while allowing for inflation of up to 2.5 percent. The bank also confirmed its intent to continue buying $85 billion of treasury and mortgage-backed securities per month.

--Caitlin O'Connell contributed to this report.