From The Wall Street Journal:

The Central Bank needs to watch asset prices and raise rates quickly when it decides the time is right.

By Nouriel Roubini and Ian Bremmer

Ben Bernanke and the Federal Reserve face a number of very difficult challenges in the years ahead. They include:

• Resisting pressure to monetize deficits, which would eventually cause high inflation.

• Implementing an exit strategy from the massive monetary easing of the past year.

• Maintaining the Fed’s independence, which has been compromised by
the direct and indirect bailout of financial institutions and
congressional attempts to micromanage the central bank.

• Properly calculating asset prices and the risk of asset bubbles
according to the Taylor rule, an important guideline central banks use
to set interest rates.

• Supervising and regulating the financial system more effectively, particularly in the role of “systemic risk” regulator.

The first two tasks are closely related. In order to prevent a
persistent monetization of deficits that would lead to inflation, the
Fed must implement an exit strategy from the unconventional monetary
easing that began in late 2008. If the fiscal and monetary stimulus is
taken away too soon, there is the risk of relapsing into deflation. If
it is taken away too late, we may eventually face a fiscal crisis and
an inflationary recession, or stagflation.

The Fed does not control fiscal policy. But to avoid a game of
chicken wherein loose fiscal policy forces the Fed to monetize deficits
to prevent a spike in bond yields, the Fed needs to pre-emptively state
it won’t be buying more Treasury bills.

As for the exit from monetary easing, the Fed must learn from the
fateful mistake it made after the 2001 recession. Then, the central
bank cut the federal-funds rate too much and kept it too low for too
long. It also moved far too slowly when the normalization occurred—in
small increments of 0.25% from summer 2004 until the summer of 2006,
when it peaked at 5.25%. Normalization took two full years. It was in
that period of slow normalization that the housing, mortgage and credit
bubbles spiraled out of control. The lesson learned: When you
normalize, move rapidly, or prepare for another dangerous bubble.

Of course, this is easier said than done. From 2002 to 2006, the Fed
moved slowly because the recovery appeared anemic and because of
significant deflationary pressures. This time around, the recession is
more severe—unemployment is at 9.8% and is expected to peak above 10%,
and we are experiencing actual deflation. Therefore, the incentive not
to exit too soon will be greater and the risk of creating another
bubble is greater. Indeed, the sharp increase in the stock market and
commodities, and narrowing of credit spreads since March, are partly
due to a wall of global liquidity chasing assets and already causing
asset inflation.

If the conflict between economic growth and financial stability
requires that monetary policy remain loose, then it is critical that
the supervisors and regulators of the banking sector move aggressively
to prevent another bubble from emerging. Thus they should quickly adopt
the regulatory reforms agreed to by the G-20—including a new insolvency
regime for financial institutions deemed “too big to fail,” a serious
approach to limiting “systemic risk,” and appropriate rules governing
incentives and compensation for bankers and traders.

It won’t be easy to define systemic
regulation and too-big-to-fail. There is a significant risk that doing
so will provide an implicit guarantee for large and complex financial
institutions. There is also a longer-term risk that actions taken by
congressional and regulatory agencies will distort global financial
markets. Western financial institutions now depend heavily on state
financial backing, and several governments have tweaked rules and
regulations to support the large financial institutions that are now at
least partially taxpayer-owned. Further, governments could increasingly
require domestic financial institutions to lend more at home, which
will curtail their foreign operations. Creating a system of effective
financial regulation—while resisting the impulse to favor domestic
institutions—will be a real challenge for most countries, including the
U.S.

Over time, once the fed-funds rate is normalized, incorporating
asset prices into monetary policy making is also necessary to ensure
financial stability. While it is correct that the fed-funds rates may
not be the most effective instrument at controlling asset and credit
bubbles, excessively cheap money is always a source of such bubbles. So
faster normalization of the fed-funds rate will eventually be
important.

The Fed’s involvement in quasi-fiscal operations creates other
challenges. As long as the Fed remains involved in maintaining
financial stability and in preventing other episodes of systemic risk,
it will be hard to eliminate the perception that the Fed will be
involved as a lender of last resort for too-big-to-fail firms. So far,
this Pandora’s Box remains open.

The way to prevent future moral-hazard distortions is to create a
regulatory regime where too-big-to-fail institutions have much higher
capital requirements: a greater liquidity buffer, lower leverage, and
lower involvement in risky and illiquid investments if they are
depository banks. They should be supervised internationally and must be
able to be closed down in an orderly fashion should failure loom.

The Fed is currently resisting a Treasury-led effort to review how
it is organized out of concern it might forfeit its independence. Yet
the governance structure of the New York and other regional Federal
Reserve banks left them effectively controlled by large financial
institutions last year, so such a review is necessary. While
congressional interference in the Fed’s jurisdiction is a danger, the
recent quasi-fiscal activities of the Fed bear a review.

The Fed also needs a greater regulatory backbone. The Fed had the
power to regulate mortgage markets but failed to use this power out of
a misplaced deference to laissez-faire attitudes and Wall Street.
Regulating mortgage markets requires a careful balance: short-term
regulatory forbearance to avoid a greater credit crunch, along with
medium-term countercyclical supervisory actions in order to prevent the
emergence of further asset and credit bubbles.

Establishing financial stability—in
addition to price stability and growth—is the essential role of the
central bank. Achieving this goal in a way that avoids moral-hazard
distortions, as with the too-big-to-fail finance institutions, and
prevents another bubble in the next years will surely be one of the
greatest challenges ever faced by the Fed.

Mr. Bremmer,
president of Eurasia Group, is co-author of the “The Fat Tail: The
Power of Political Knowledge for Strategic Investing” (Oxford
University Press, 2009). Mr. Roubini is a professor of economics at New
York University’s Stern School of Business and chairman of RGE Monitor.