Yesterday, it became clear that the Federal Reserve has become increasingly discordant over the course of monetary policy, and that’s just with regard to the traditional question of when to raise rates. Last week, Karen Petrou’s memo laid out an even more worrisome challenge: the FRB’s lack of tools not only to conduct effective monetary policy, but also to protect financial stability. The FRB has come to understand that neither macroprudential rules nor monetary policy is sufficient to ensure financial stability, especially during cyclical booms and busts, but it has yet to agree on what now to do to ensure sound growth and stable markets.

We think we know what’s bedeviling the FRB and have laid this out in several recent studies you can find on our website: the rapid transformation of U.S. finance into a system far less dependent on banks. This might be good for innovation and diverse product offerings, but it creates awesome regulatory asymmetries that redefine financial intermediation and, with it, the ability of the FRB to ensure that its interest-rate actions translate into meaningful market responses with desired policy results.

A recent conference at the Federal Reserve Bank of Boston confirmed this conclusion, albeit without laying out any solutions. In her memo and a speech earlier in the week, Karen details the most critical questions the FRB needs to ask and the financial-services industry should help it quickly to answer. First and foremost is what happens to financial intermediation when key activities are turned from principal to agent operations. This isn’t just an academic question – a lot of long-term profit rides on getting the winners and losers right. Even more immediate, though, is the question of how financial intermediation functions under two rate scenarios: a gradual rise, which could put banks at a major disadvantage if current deposit rates don’t prove as sticky as most models anticipate and, even more worrisome, what would happen if rates stay low or, worse, go into nominal negative. This may seem academic, but Ben Bernanke today again suggested that the FRB may be forced to do this.

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