100 Years Later, What's Become Of Our Federal Reserve?
The Federal Reserve is one hundred years old, and it is celebrating its centenary by embarking on grand plans for the future. Those plans include experimental approaches to monetary and regulatory policy. Amid this celebration and experimentation, the recently released annual report of the Federal Reserve Bank of Richmond asks whether the Fed has lost its way. Many signs suggest that it has. No longer an independent monetary policy setter, the Fed is becoming an arm of the Department of Treasury and a second-rate regulator of large financial institutions.
The Fed's actions during the financial crisis-while driven by the universal desire to avoid a second depression-corroded the underpinnings of our market system. Working closely with the Treasury, the Fed took the lead in rescuing the nonbank American International Group (AIG) and in designing countless broader rescue programs. Creditors and shareholders of banks and nonbanks alike were shielded from the risks they had assumed.
The Richmond Fed's annual report article, of which the bank's president Jeffrey Lacker is an author, questions these rescue efforts, similar past interventions, and the Fed's continuing focus on financial stability. Lacker and his co-author explain that the Fed, through rescues beginning in the 1970s, built market expectations of future rescues and accordingly undermined the market's built-in brakes on risk-taking. They conclude that:
The real lesson of the Fed's first 100 years is that the best contribution the Fed can make to financial stability is to pursue its monetary stability mandate faithfully and abstain from credit-market interventions that promote moral hazard.
They recommend, among other things, deleting section 13(3) from the Federal Reserve Act-the infamous provision that the Fed relied on to bail out AIG. Although Dodd-Frank narrowed the provision to preclude one-off rescues, the provision remains intact for broad-based rescue programs. For the Fed's brilliant and talented staff, designing such a program to work especially well for a particular ailing company would not be too difficult.
The crisis ended, but the Fed's activism and its cozy relationship with the Treasury did not. The central bank now dabbles routinely in fiscal policy. By keeping interest rates low and insisting that its regulated entities buy Treasury securities, the Fed indulges a profligate government that spends without regard to mounting debt burdens.
The Fed's policies favor politically powerful industry sectors. Its massive purchases of mortgage-backed securities, for example, support the ever-demanding housing sector. Fed chairman Janet Yellen explained in a recent speech - a heart-tugging discourse that could serve as a worthy model for a stumping politician - that the Fed is working hard to "create jobs," "revive the housing market," and spur "the revival of the auto industry." In order to do so, it is going to great lengths to keep interest rates low, which helps borrowers and big spenders like the government, but hurts savers and retirees and encourages investment dollars to flow into higher-yielding, riskier assets.
To complement its monetary policy tools, the Fed is aggressively wielding the new regulatory powers given to it by Dodd-Frank and seeking to broaden its regulatory jurisdiction. In doing so, it is ceding its own independence; in its regulatory role, the Fed is no more entitled to independence than any other financial regulator.
Dodd-Frank gave the Fed more power over bank holding companies and new power over savings-and-loan holding companies. It also regulates any financial company designated "systemically important." Yet the Fed does not have any particular facility for such regulatory endeavors. Just this week, it announced that it is hiring a former state insurance regulator to help the central bank in its new role as regulator of designated insurance companies. It is also eyeing companies in the asset management and brokerage businesses.
Through stress testing and a new macroprudential regulatory approach, the Fed is subtly substituting its own judgment about acceptable risks for those of private decision-makers. To be effective in this endeavor, the Fed believes it needs to extend its regulatory reach beyond banks to clamp down on risk-taking in the capital markets.
The Fed's first hundred years are over, and it is aggressively planning its second century. It may be willing to trade its independence for additional powers, but Congress must not allow that to happen. If we are to have a central bank, it should focus on monetary stability, refrain from rescuing failing companies, and leave the politicking, fiscal game-playing, and regulating to entities and individuals that don't claim to be independent.