web analytics

What is the Fed?

The Federal Reserve Bank System is a unique hybrid public-private bank network whose 12 district members are owned by local banks and regulated by a 7-person Board of Governors, each of whom are appointed for one 14-year term by the White House. It was created in 1913 and amended in 1935 primarily to use monetary policy to deal with cyclical bank panics. Congress established three key objectives for monetary policy in the Federal Reserve Act:

  • maximum employment
  • price stability
  • moderate long-term interest rates

The private banks give input to the government officials about their economic situation and these government officials use this input in Federal Reserve Board policy decisions.

How does the Fed employ monetary policy?

Monetary policy should ideally be used in conjunction with fiscal policy as a means to achieve desired national economic objectives. In America monetary and fiscal policies mostly are independent of each other. Congress and our President have led America to the brink of a “fiscal cliff”, and no comprehensive fiscal policy reform seems likely in the near term. This state of affairs has thrust the Federal Reserve Board, and its Chairman Ben Bernanke, to the forefront as the savior/enabler of today’s American macro economic policy.

The primary tools of the Federal Reserve Board are:

  • to set bank reserve requirements
  • to set the discount rate for interest paid by the Fed on bank reserves
  • to conduct Open Market Operations that seek to influence the Fed Funds rate (that is paid by banks to each other for short term borrowings) via open purchases and sales of US Treasury and federal agency securities

Minutes of the regular meetings of the Fed’s Open Market Committee (FOMC) are widely published by the media in order to inform business and banking leaders about probable Fed actions. The Fed has said it doesn’t expect to touch short-term rates until it sees the unemployment rate fall to 6.5% or lower, as long as inflation forecasts remain near its 2% target. That would mean, according to the Fed’s economic projections, that it would keep short-term rates near zero into 2015.

” In case there was any doubt about its resolve, the Fed statement also issued a new implicit annual inflation target: 2.5%. The official target is still 2%. But the Open Market Committee stated that it will keep interest rates near zero, and by implication keep buying bonds, as long as the jobless rate stays above 6.5% and inflation stays no more than a half-percentage point above the Committee’s 2-percent longer-run goal…That is a 2.5% inflation target by any other name, and it’s striking to see a central bank in the post-Paul Volcker era say overtly that it wants more inflation.”  WSJ, 12/12/12 “The Fed’s Contradiction”

Many economists think we have to inflate our way out of the debt crisis. Inflation remains quiescent, but central banks that ask for more inflation likely get it. The Fed is now buying about 70% of new long-term Treasury debt, and when you add “QE3” debt purchases, it appears to be well on its way to monetizing not only the deficit, but also a large chunk of the accumulated federal debt.

Why do the Fed’s policies matter?

Fed policy continues to punish thrift and reward irresponsible debtors. A 2.5% inflation rate and interest rates on deposits near zero compounded diminishes the real value of saving by 1/2 over only 28 years even absent any income or taxes. This is a tax on our middle class. Benefits for those receiving government benefits will be indexed to a CPI. The rich can make investments in hedge funds, private equity and other vehicles that can earn better than inflation adjusted returns after taxes. It is those who have long worked and saved who will pay these penalties.

By keeping interest rates ultra low, central banks including the Federal Reserve may have likely created a ticking time-bomb for investors in the bond market. The risk is that the many retail (middle class) investors who sought safety in bonds don’t fully understand the losses they will face if there is a sustained economic recovery and yields start to rise.

The Fed’s near-zero interest rate policy will continue to disguise the real cost of government borrowing. One reason the Obama Administration can keep running trillion-dollar deficits is because it can borrow the money at bargain rates courtesy of the Fed. Each 1% increase in rates on a $16 trillion federal debt is $160 billion per year, and those increases must begin sooner or later.

For the past four years the Fed has maintained expansionary and unconventional policies and we are told there is still no end in sight. Mr. Bernanke famously failed to predict the 2008 monetary crisis, and then was slow to react (although he did so effectively). Now we are supposed to believe he will know when to pull the ripcord on growing his balance sheet. The Fed and Mr. Bernanke may well be geniuses and get it all just right this time, but Diogenes is not optimistic that this will happen.

4 Comments

  1. avatar

    davidr says:

    This whole subject gives me a headache. Why can’t the fed print all the money the gov’t needs and we can just not pay any taxes? Sounds silly. Sounds absurd. Sounds criminal. And yet that’s the way it’s kind of going. The US prints 46 cents out of every dollar it spends now, so we’re halfway there.

    The main arguments against my suggestion above are: 1) inflation; and 2) currency depreciation. Well where’s the inflation from the going halfway as we’re doing now? And if the fed buys all the debt, well where’s the problem with interest rates or currency?

    I know it’s all baloney what I’m saying, but it sounds less and less like baloney as I view this train wreck in motion.

  2. avatar

    Nelson says:

    As always Dave, thanks for your comments. What the Fed is doing is essentially incomprehensible to me. It is a train wreck in slow motion.

  3. avatar

    Joel S says:

    Good presentation of the Fed and current monetary policy, though there is an implicit message: the the Fed will not be successful and is or will be therefore at fault.

    A more complete analysis would address the role of fiscal policy and the necessity for Congress and also the Administration to find a compromise that sets the economy on a positive, long term track. While this is no doubt a difficult task, given the polarization in our two political parties, it is what needs to happen.

  4. avatar

    Nelson says:

    Thank you Joel. Of course fiscal and monetary policy are far more effective when used together. I can’t agree more that failure to achieve a “grand bargain” on fiscal policy reflects a lack of leadership from the White House, as Congress is too split to agree on much of anything.

    We are in a “liquidity bubble”. When we went through the “internet bubble” and the “housing bubble”, many were aware that the markets were severely distorted and the situation was inherently unstable. No one knew when it would blow up, only that it eventually would. I hope I am wrong, Bernanke is a genius and “this time is different”, but I don’t think so. The Fed has been facilitating fiscal irresponsibility. It’s policy tools are less and less effective, but are not being scaled back, making the reckoning more painful whenever it arrives. So I believe that in hindsight, we will determine that the Fed added fuel to the eventual fire.

Leave a Reply