Finally, as we revisit our central bank lending policies, we must not overlook the importance of central bank independence. The record shows that central bank independence leads to more effective monetary policy. That principle is vital to our lending policy as well.

To protect that independence, central bank lending policies should avoid straying into the realm of allocating credit across firms or sectors of the economy, which is best left to the marketplace. The perception that the Federal Reserve is in the business of allocating credit is sure to generate public pressures on the Fed from all sorts of interest groups. In my view, if the government must intervene in allocating credit, it should be the responsibility of the fiscal authority rather than the central bank. This division of labor, so to speak, will better ensure the Fed's ability and credibility to maintain price stability and promote economic growth.

This expansion of the scope and scale of Fed lending may not have been so large had we had better resolution mechanisms to deal with such failing firms as Bear Stearns and AIG. And perhaps our lending would not have become so wide-ranging had there been better regulation or more resiliency in the payment and settlement systems, including more transparency about the markets for mortgage-backed securities and credit default swaps.
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Some may think access to the Fed's lending facilities should be permanently expanded to include a wide range of financial institutions. I believe such expanded access to central bank credit would raise significant issues of moral hazard that would need to be addressed. And I have urged that we must continue to avoid compromising the Fed's independence — one of the great strengths of central banks.

Some people might think that expanding the Federal Reserve's regulatory and supervisory authority and giving it a sweeping mandate for financial stability would prevent the types of financial crises we have been experiencing this year. That is unrealistic.

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Going forward our focus should be on better regulation, not necessarily more regulation. We need to focus on ways to strengthen our financial markets to make market discipline more effective at mitigating systemic risk. We should think about which financial markets are critical to the efficient functioning of the payment system rather than focusing on individual firms. Ideally, we need to determine which aspects of the financial system are critical and then make sure we have the market mechanisms, regulations, and supervision to ensure those sectors are resilient.

{In reference to separating the Fed from other institutions by adding responsibilities} I think it's likely to emerge as a theme. I think it ought to be front and center in the discussion about financial regulatory reform and restructuring if Congress would like to go down that path, restructuring regulatory responsibilities at the federal level. Our paramount responsibility is keeping prices stable, inflation low and steady. There are other responsibilities we have accumulated over the years. And we have, as a result of our history, where we came from, and various responsibilities that have been given to us. But our ability to exercise independent judgment about the level of the policy rate, I think, is quite important. And I do see some merit to the argument that adding responsibilities can threaten to dilute the independence that we need for that responsibility.

Since the credit crisis began last August, the Fed has expanded the volume and types of loans it is willing to make to banks and securities dealers -- loans that are backed by a wide variety of collateral from subprime mortgages to student loans...

Mr. Volcker, testifying on responses to the credit crisis at the Joint Economic Committee of Congress Wednesday, said such activity "has not been the tradition of the central bank and I think that is an issue for the long run for the independence of the central bank. If it is going to be looked to as the rescuer or supporter of a particular section of the market, that is not strictly a monetary function in the way it's been interpreted in the past."

As reported by the Wall Street Journal

If a central bank is to assume the responsibility of being a lender of last resort, it should clearly articulate its objectives in doing so. It should make credible that commitment and act in a way that is consistent with that commitment. It should clearly communicate its lending policies to the public. What’s more, the independence of the central bank’s decision making from short-term political interference is essential to sound policymaking in this arena as well.

Fixed, or partially fixed exchange rate regimes, of course, also constrain the independence of monetary policy. As capital accounts become progressively more open, few countries can sustain over time a commitment to exchange rate stability without risking price stability. Eventually central banks will run up against limits on their capacity to sterilize the effects of exchange market intervention designed to limit the pace and extent of appreciation of the exchange rate. Although measured inflation in emerging Asian economies remains relatively low, the pace of credit growth and the behavior of asset prices provide some evidence of a growing tension among competing objectives. The longer this policy conflict persists, the greater the distortions building up in the economy, the greater the risk of future inflation and the greater the risk of a bumpy future.

Despite the favorable results attained by inflation-targeting countries over time, our evidence generally does not suggest that countries that adopt inflation targeting have improved their monetary policy performance beyond that of our control group of nontargeters, all of which are industrial countries with a successful monetary policy...

Nevertheless, the adoption of inflation targeting can have advantages even for industrial countries. Industrialized countries that have not adopted inflation targeting face four problems (see Bernanke and others, 1999; Mishkin, 2005). First, the strong nominal anchor that produced a successful monetary policy is often based on individuals, and their replacements may not be strongly committed to the nominal anchor. Second, the focus on the long run exhibited by successful nontargeters may weaken in the future. Third, the lack of transparency about the goals of monetary policy increases uncertainty. Fourth, the lack of accountability in the absence of inflation targeting could undermine central bank independence in the future, thereby weakening the nominal anchor.  Inflation targeting has the potential to ensure that the successful monetary policy performance of our control group of industrial nontargeters in recent years continues in the future.

[T]here is a further reason why I believe that a central bank should not put too much focus on asset prices. Such a focus can weaken its public support, making it harder for it to successfully conduct monetary policy to stabilize inflation and employment.

A central bank that focuses intently on asset prices looks as if it is trying to control too many elements of the economy. Part of the recent successes of central banks throughout the world has been that they have narrowed their focus and have more actively communicated what they can and cannot do. Specifically, central banks have argued that they are less capable of controlling real economic trends in the long run and should therefore focus more on price stability and damping short-term economic fluctuations. By narrowing their focus, central banks in recent years have been able to increase public support for their independence. A central bank that expanded its focus to asset prices could potentially weaken its public support and may even cause the public to worry that it is too powerful and has undue influence over all aspects of the economy.

Independence is the freedom to pursue a defined monetary policy objective without consideration of political or private interests, and without fear of subordination to other economic policy objectives...Independent central banks do, in fact, do a better job of achieving price stability. The greater the independence of the central bank, the lower the average level of inflation and the less volatile the inflation rate

The public has a right to know what its unelected, as well as elected, officials are doing, and why. And this is the reason that transparency is so important for supporting the independence of the central bank. Transparency facilitates a broad understanding of what the central bank is doing and thereby gives the public the tools to hold the independent central bank accountable. Transparency, in fact, can play a valuable role in reinforcing the institutional independence of a central bank