A regulatory backlash is under way as the US body politic comes to grips with the financial crisis. Wall Street – or what is left of it – is first in the line of fire. But the era of excess was as much about policy blunders and regulatory negligence as about mistakes by financial institutions. As Washington creates a new system, it must also redefine the role of the Federal Reserve.

Specifically, the US Congress needs to alter the Fed’s policy mandate to include an explicit reference to financial stability. The addition of those two words would force the Fed not only to aim at tempering the damage from asset bubbles but also to use its regulatory authority to promote sounder risk management practices. Such reforms are critical for a post-bubble, crisis-torn US economy.

This is not the first time the US Congress has needed to refine the Fed’s mandate. After the great inflation of the 1970s, the so-called Humphrey-Hawkins Act of 1978 was enacted. That required the Fed to add price stability to its original post-second world war policy target of full employment. In the late 1970s, Congress felt the Fed needed the full force of the law to tackle a corrosive inflation problem. This legislative change empowered Paul Volcker, a later Fed chairman, in his courageous assault on double-digit inflation.

By focusing on financial stability, the Fed will need to adjust its tactics in two ways. Firstly, monetary policy will need to shift from the Greenspan-Bernanke reactive, post-bubble clean-up approach towards pre-emptive bubble avoidance. Second, the bank will need to be tougher in its neglected regulatory oversight capacity.

By adding “financial stability” to the Fed’s policy mandate, I am mindful of the pitfalls of multiple policy targets. However, single-dimensional policy targeting does not cut it in a complex world. As such, the Fed will need to be creative in achieving its mandated goals – using monetary policy, regulatory oversight and enforcement and moral persuasion. Just as the Fed has been reasonably successful in its twin quests for price stability and full employment, I am confident it can rise to the occasion with the addition of financial stability to its mandate.

I am not suggesting the Fed develops numerical targets for asset markets. It should have discretion as to how it interprets the new mandate. Yes, it is tricky to judge when an asset class is in danger of forming a bubble. But hindsight offers little doubt of the bubbles that developed over the past decade – equities, residential property, credit and other risky assets. The Fed wrongly dismissed these developments, harbouring the illusion it could clean up any mess later. Today’s problems are a repudiation of that approach.

There is no room in a new financial stability mandate for bubble denialists such as Alan Greenspan, the former Fed chairman. He argued that equities were surging because of a new economy; that housing forms local not national bubbles and that the credit explosion was a by-product of the American genius of financial innovation. In retrospect, while there was a kernel of truth to all of those observations, they should not have been decisive in shaping Fed policy. Under a financial stability mandate, the Fed will need to replace its ideological convictions with common sense. When investors buy assets in anticipation of future price increases the Fed will need to err on the side of caution and presume that a bubble is forming that could threaten financial stability.

The new mandate would also encourage the Fed to deal with excesses by striking the right balance between deploying its policy interest rate and other tools. In times of asset-market froth, I favour the “leaning against the wind” approach with regard to interest rates – pushing the Federal funds rate higher than a narrow inflation target might suggest. But there are other Fed tools that can be directed at financial excesses – margin requirements for equity lending as well as controls on the issuance of exotic mortgage instruments (zero-interest rate products come to mind). In addition, the Fed should not be bashful in using the bully pulpit of moral persuasion to warn against the impending dangers of asset bubbles.

Of equal importance is the need for the Fed to develop a clearer understanding of the linkage between financial stability and the open-ended explosion of derivatives and structured products. Over the past decade, an ideologically-driven Fed failed to make the distinction between financial engineering and innovation. It understood neither the products nor their scale, even as the notional value of global derivatives hit $516,000bn in mid-2007, the eve of the subprime crisis – up 2.3 times over the preceding three years to a level that was 10 times the size of world gross domestic product. The view in US central banking circles was that an innovations-based explosion of new financial instruments was a huge plus for market efficiency.

Driven by its ideological convictions, the Fed flew blind on the derivatives front. On the one hand, this was hardly surprising as these are largely private, over-the-counter transactions. What is surprising is that the authorities failed to develop metrics that would have helped them understand the breadth, depth and complexity of the derivatives explosion. This trust in ideology over objective metrics was a fatal mistake. Like all crises, this one is a wake-up call. The Fed made policy blunders of historic proportions that must be avoided in the future. Adding financial stability to its mandate is vital to preventing such errors again.

The writer is chairman of Morgan Stanley, Asia

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