The Fed Needs to Earn Its Independence. Just Setting Rates Isn’t Enough.

Renovation work continues on the Marriner S. Eccles Federal Reserve Board Building, the main offices of the Federal Reserve System in Washington, D.C. (Andrew Harnik/Getty Images)

About the authors: Mickey D. Levy is a visiting fellow and Amit Seru is a senior fellow at the Hoover Institution at Stanford University. Seru is also a professor of finance at the Stanford Graduate School of Business.

The Federal Reserve faces big issues that extend far beyond choosing what interest rate will best achieve its dual mandate.

It juggles an abundant balance sheet, short-term funding markets, bank supervision and stress tests, and a fast-growing but opaque private-credit complex. At the same time, the Fed must manage to maintain macroprudential guardrails for financial stability and take accountability when those guardrails fail. The success of its monetary policy depends on it.

History explains why. From the 1970s to the Covid-19 pandemic, the Fed swung between excessive monetary easing, generating high inflation and easy credit, to aggressive tightening. Each of its deviations from systematic policy ignored well-known guides and critical aggregates. They sowed financial imbalances that later demanded emergency rescues. Stress tests assumed falling rates; instead, rates rose and duration risk detonated on bank balance sheets.

The Fed should realize that promoting financial stability isn’t a follow-up chore after it completes its “real” work—setting monetary policy. Financial stability is entangled with monetary policy, and it must be addressed systematically. Here is how.

First, Congress and the Fed should formalize the split between monetary policy and policies around financial stability inside the Fed. Create two distinct committees with independent mandates: one focused on price stability and maximum employment and the other on systemic risk and oversight. Coordination is essential for accountability; commingling isn’t. Separate responsibilities reduce reputational spillovers. The same people who police banks on Tuesday shouldn’t be the ones to rescue the banks on Friday.

The 2010 Dodd-Frank Act took a half step toward this division by creating a vice chair for supervision. Congress should update the role to vice chair for financial stability, with the explicit remit to monitor systemwide conditions, maintain real-time data sets, and develop predictive tools for instability. Other leading central banks have such a structure. The Fed should too.

Second, separate large-bank supervision within the Fed. Establish a distinct bank supervision board with its own statutory mandate, governance, and reporting—akin to the Bank of England’s Prudential Regulation Authority. Keep bank supervision inside the Fed to preserve access to supervisory information that a credible lender of last resort must have and to avoid any biases and politics that may come with moving such responsibilities to the executive branch. The goal isn’t distance for distance’s sake. It is clean accountability and fewer conflicts when supervision and backstops intersect.

Third, require banks to mark-to-market their entire balance sheets and off-balance-sheet exposures and share details with the Fed on a regular basis. Banks already model these risks internally; Fed supervisors should be able to see the same numbers and sensitivities. When rates rise 300 basis points, a long-duration portfolio’s losses aren’t “opinions.” Transparent marks sharpen risk management, curtail regulatory forbearance, and make resolution decisions faster and fairer.

Fourth, set rules around emergencies. The Fed’s use of Section 13(3), which gives it emergency lending tools from special facilities to sweeping asset purchases, should follow predefined guidelines with bright-line triggers, mandatory disclosures, cost-benefit analyses, and postcrisis evaluations. This would help mitigate improvised interventions involving fiscal and credit policy transfers.

Fifth, the Fed must upgrade its quarterly Summary of Economic Projections to be more candid about its interest rate policy and balance sheet. Each SEP must include Taylor-rule estimates of dots that would deliver the Committee’s central-tendency inflation and economic projections, plus information on the Fed’s balance sheet.

Once a year, the Fed should present a scenario analysis that maps different policy rates consistent with alternative inflation and employment paths. In its semiannual Monetary Report to Congress, the Fed should explain why any balance sheet enlargement, especially purchases of non-Treasuries, is necessary to achieve its dual mandate and provide mark-to-market measures of its balance sheet. These steps wouldn’t handcuff discretion; it would discipline it.

Sixth, fix the stress tests. The Fed’s “severe adverse” scenarios always assume deep recessions and falling rates. They largely missed the urgency of rising-rate exposures, which helped sink Silicon Valley Bank and First Republic Bank in 2023. Bake parallel interest-rate shocks, both up and down, into every test. If a bank cannot survive higher rates without extraordinary support, we should learn that in stress tests—not in an emergency rescue.

Seventh, publish a dual-mandate score card. After each Federal Open Market Committee meeting, present a simple, public table that links policy choices to inflation, employment, and financial-stability risks. Show how the projected monetary policy path achieves the Fed’s mandate and what it endangers if it goes wrong.

Finally, stay ahead of private credit. As lender of last resort, the Fed must understand the nonbank balance sheets that now intermediate a growing share of credit. It should request confidential data from large private-credit platforms and custodians to gain a full understanding of credit markets—before shocks occur.

None of this elevates financial stability into a third mandate for the Fed. It recognizes that sound monetary policy alone isn’t sufficient to maintain financial stability. The Fed’s independence is essential, but it must be earned. Transparency and accountability require aligning its operations, procedures, and communications to meet its objectives in more systematic and comprehensive ways.

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