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Some astute commentators have recently noted that while the Fed's highly stimulative monetary policy is in keeping with their dual mandate to maintain low and stable inflation and pursue maximum employment, their policy choices might be risking broader financial stability. Although this assertion does an excellent job highlighting the fragility of our current financial system, it largely neglects the fragility of the ongoing economic recovery.

Over the last few weeks near economic euphoria has faded to the reality of a slow and unsteady economic recovery in the U.S. During this time, Fed officials have pivoted from talking about "tapering" asset purchases to the possibility of increasing asset purchases. Aside from cuts to government spending, the main drag on the U.S. economy continues to be weak global growth. In fact, central banks around the world are once again discussing increased stimulus, as dropping inflation has raised the specter of deflation, while unemployment remains unacceptably high in many countries, and still rising throughout much of Europe.

Essentially, persistent weakness in the global market suggests that even absent the Fed's mandate to pursue full employment, Fed officials might very well be engaging in stimulative open market operations. So, with unemployment remaining unacceptably high, it is obvious why the Fed feels justified in pursuing continued asset purchases. The only remaining question is whether persistent economic weakness will force them to increase asset purchases.

At this point, most Fed watchers agree that the FOMC is unlikely to move toward increased asset purchases at this time, but these Fed watchers tend not to agree as to why. In particular, the lack of inflationary pressure and the presence of disinflationary pressure suggests that the Fed might well be justified in pursuing further quantitative easing. Oddly, it may very well be the Fed's employment goals that are restraining present policy. In particular, the Fed's lack of success stimulating the labor market with asset purchases has left them subject to sharp critique over the past few years and potentially limited their ability to engage in stimulus due to reputational concerns.

One of the people most acutely aware of this delicate balance between stimulative policy, the labor market and the Fed's credibility over the past few years has been Fed Vice Chairwoman Janet Yellen. Dr. Yellen's intense focus on employment has largely been adopted by the larger body with several regional bank Presidents devising plans to target certain unemployment rates under certain inflationary circumstances.

The influence of the Vice Chairwoman is particularly noteworthy this year as Chairman Bernanke has announced that he will skip the annual Jackson Hole Symposium, fueling speculation that he will be leaving the Fed in 2014 with Dr. Yellen as his most likely successor. Should Dr. Yellen become Fed Chairwoman, it is obvious that not only is the dual mandate going to persist, stimulating employment will likely remain at the forefront of Fed policy for several years.

Given that softening economic conditions and current/future Fed personnel suggest that stimulus will persist for some time, it remains an open question as to how the Fed intends to maintain financial stability if their very actions are destabilizing. Adding to this concern is the revelation that some central banks have recently been reaching for yield by investing in equities; this type of action poses substantial risk to global financial markets beyond the more general risks posed by continuously increasing liquidity.

Despite growing critiques of these risky central bank behaviors, the loudest criticism has almost exclusively focused on the Fed's recent push to force foreign banks operating in the U.S. to follow the same capital standards as U.S. banks. These sharp rebukes have included accusations of protectionism and threats of slowing economic growth. In other words, global financial institutions want continued economic stimulus with no added systemic risk and no additional regulatory barriers that could infringe on profits for the sake of financial stability.

For the time being, it looks like they might just get their wish. While I do believe that financial institutions will face increased capital standards in the future, this modest regulatory burden will hardly offset the risk or rewards generated by continued asset purchases. This means that investors should be very wary of downside risks associated with continued economic stimulus, especially as central banks reach for yield, but more immediately, investors need to keep close watch on the fight over increased capital standards; this battle will have an enormous impact on the profitability of both foreign and U.S. financial stocks.

Source: The Dual Mandate And QE3