We Vastly Exaggerated the Fed's Powers

These are worrying days for the Federal Reserve, America's central bank. Surrounded by critics on the left and right, it can hardly do anything without being second-guessed or denounced. Last week, the Fed decided not to raise its target "fed funds" rate, a move that was praised by some economists but was greeted by steep drops in stock prices. This captures the Fed's precarious position: supported by some, scorned by others.

Over the past decade, there has been a profound shift in its public standing. Before the 2008-09 financial crisis, the Fed enjoyed enormous prestige and freedom of action. All the Fed had to do, it seemed, was tweak short-term interest rates to keep expansions long and recessions short. What's clear now is that we vastly exaggerated the Fed's powers of economic management.

Since 2008, the Fed has not only kept short-term interest rates near zero but has also poured nearly $4 trillion into the economy by buying U.S. Treasury securities and mortgage bonds (so-called "quantitative easing," or QE). These policies almost certainly helped the economy, but the extent of the help is unclear and subject to legitimate disagreement. Regardless, the recovery has been frustratingly slow.

The Fed's reputation has suffered. Increasingly forgotten is its success during 2008 and 2009 in preventing another Great Depression by acting as "lender of last resort" for the financial system. Instead, Fed policies are misleadingly identified as part of the problem and in need of overhaul. The results could be perverse, as long-term Fed observer John M. Berry (who covered the Fed for The Washington Post and other media) writes in The International Economy magazine:

"Under the rubric of ‘Fed reform,' [critics] want to take away some of the key powers the central bank used, first, to keep the United States from falling into a depression . . . and, second, to bolster the slow recovery over the past six years."

Berry cites two examples. Some congressional Republicans favor proposals requiring the Fed to set monetary policy according to a rule or formula. Short-term interest rates would be set more or less automatically. A predictable rule, it's argued, would bolster confidence by limiting economic uncertainty. But as Berry writes, economic conditions change too erratically to justify a rigid rule. In 2008, a rule might have handcuffed the Fed's response to the financial crisis. The main source of economic uncertainty today is not Fed policy but the behavior of the private sector - consumers and companies.

Berry's second example comes from proposed legislation by liberal Sen. Elizabeth Warren (D-Mass.) and Sen. David Vitter (R-La.). It would impose new requirements on the Fed before it could lend to ailing financial institutions. The aim is to prevent "backdoor bailouts." But in practice, argues former Fed chairman Ben Bernanke on his blog, it would hamstring the Fed's ability to prevent banking panics. More financial crises might ensue.

The Fed is increasingly friendless. The sluggish recovery has turned it into a scapegoat. What we should have learned is that its powers, though considerable, are limited. Years of ultra-easy credit have not triggered the faster growth that most Americans desire. Even with the economy near "full employment" (August's unemployment rate: 5.1 percent), living standards are barely budging.

There are explanations for this. One is that the financial crisis and Great Recession so traumatized consumers and businesses that they reined in their spending and risk-taking. If so, the effect will probably fade with time. As debts recede and savings accumulate, firms and households will feel more confident. A second explanation is grimmer. It is that the dynamism of the U.S. economy has declined. If true, gains in living standards will be slower than in the past.

But the Fed can't solve either of these problems. At most, it can make a modest contribution by promoting economic stability and ensuring that high inflation does not return. It would be tragic if the disappointment with the slow recovery led to restrictions on the Fed that, though popular now, made us more vulnerable to economic and financial crises later.