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.
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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.
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