What is the Federal Reserve?
The experience of several market panics and financial crises in the 19th century encouraged policy makers to create a central bank with the power to maintain liquidity and avoid deflationary spirals. Following the Panic of 1907, the Federal Reserve (often shortened as the “Fed”) was created to control the monetary policy of the US. The Fed’s dual mandate is to keep prices stable, while maximizing employment. The Fed’s power to influence the economy is well known, but the economy remains quite weak several years after the 2008 financial crisis. As a result, the Fed’s authority and independence have been subject to greater than usual criticism. In an effort to defuse these attacks, and promote understanding, the Federal Reserve has recently changed its communication policy.
What key powers does the Federal Reserve have?
Without diving into detailed macroeconomics, consider this simplification: price inflation is a function of the size of the monetary base and the velocity of money. The size of the monetary base is essentially the supply of money in the economy, while the velocity of money is a measure of how quickly money changes hands.
Let’s start with the velocity of money. In a recession, the economy slows down and we (investors and consumers) spend less, invest less, and hoard cash. In other words, the money in the economy doesn’t move around. When collective demand for goods and services fall, money is traded less and, the result is deflation: lower prices for goods & services. Again, the Federal Reserve’s job is to maintain prices and avoid a deflationary spiral. So, how does the Fed keep prices stable in a recession?
The Fed has tools to control the size of the monetary base. For example, the Fed can lower the capital requirements (how much money must be kept in reserve) for banks, giving them more money to lend, and thereby increasing the monetary base. The Fed can also lower the interest rate that key banks charge each other – the all important Federal Funds Rate – which makes raising cash (for additional lending) easier to procure. Similarly, the Fed works with the US Treasury to print more money for Federal Reserve banks, directly injecting available money into the system.
During an economic expansion, the worry instead is runaway inflation: prices for goods and services going too high, too quickly. In an overheated economy, the Fed uses its powers to decrease the monetary base. For example, the Fed may increase the Federal Funds Rate rates, which makes inter-bank borrowing more expensive. Increasing the Federal Funds Rate indirectly leads to increases in ordinary investors’ savings-account rates, so investors have a greater incentive to park their money in a savings account (instead of investing it or spending it). The Fed may also increase capital reserve requirements, so banks simply have less of their money available to lend.
In either situation, the Fed tries to offset or counter-balance the forces in the economy to keep prices stable. Monetary policy gets significantly more complex, and macroeconomists could detail the many intricacies between the discount-rate, federal funds rate, various lending facilities, and so on, but – for the limited purposes of this white paper – this is essentially how the Fed works.
The Federal Reserve’s reaction to the 2008 Financial Crisis
When Ben Bernanke took over the Federal Reserve in 2006 from Alan Greenspan, the conventional worry was if anyone would keep the ship steered as well as Greenspan had during his 19 year tenure. In the wake of the 2008 housing and financial crisis, historians have been less generous to Greenspan’s reputation. He is accused of inadvertently keeping interest rates too low for too long after the 2001 technology crash, allowing the housing bubble to inflate. To his credit, former Fed Chief Alan Greenspan warned Congress about the growing housing bubble as early as 2004. He specifically noted the improper presumptions of safety in the housing and mortgage market and argued for reforms of Fannie Mae & Freddie Mac. Still, as most of these warnings were not addressed, the housing bubble ultimately collapsed and the financial system was thrown into shock.
Atypical actions by the Federal Reserve and new criticism
The Fed reacted to the subprime mortgage crisis and worldwide financial crisis in a variety of ways. As the markets unwound in 2007 and 2008, interest rates – the primary lever used by the Fed - were cut to zero. Money was injected into the system through the traditional methods, but economists worried that these efforts were insufficient. There was a very real fear that the United States was headed for a deflationary spiral of failed banks, falling prices, and a long and painful depression.
Again, the primary tool the Federal Reserve uses to counter-balance a stalling economy is lowering the Federal Funds Rate. However, by late 2008, interest rates had dropped to their theoretical limit: zero. Chairman Bernanke, a student of the Great Depression, demonstrated a willingness to use unconventional tools and emergency powers to prevent a similar deflationary spiral - even after the worst of the crisis had past. By late 2008, quantitative easing programs (QE1) were started to greatly expand the balance sheet – the list of all of the owned assets - of the Federal Reserve. Recall that the starting point of the crisis is the housing market, and the Federal Reserve wanted to prevent the underlying value of the bond market from collapsing. The Federal Reserve bought up mortgage-backed-securities and the Fed’s balance sheet doubled in size, from roughly $1 to $2 trillion. Why should buying mortgage-backed-securities help? As available supply goes down, prices go up and the bonds largely retain their face value despite questions of their underlying worth. Similarly, as prices stayed up for these assets, yields stayed low. Soaking up this much debt had a significant impact on the total available pool of bonds, indirectly supporting prices, and keeping the required interest rates low for many debt securities.
The Fed used other extraordinary measures during throughout the financial crisis. The Fed bailed out bad banks with cash infusions, replaced toxic loans with cash, soaked up slack demand in mortgage market, arranged quick takeovers of troubled banks (e.g. – the sale of Bear Sterns to JP Morgan) with nonrecourse loans, supported money market funds, facilitated consumer level auto & student loans, and provided emergency loans to AIG. Truly, the Federal Reserve became an incredibly active force trying to prevent a seize-up of the credit markets.
In the wake of these actions, some criticism can be fairly applied. One criticism is that the Federal Reserve was trying to head off effects of a recession – the symptoms - without fixing the underlying causes that led to the recession. The Fed bought up (directly and indirectly) bad loans created with lax, even negligent, underwriting standards. The fear is that, by absorbing the outstanding debts and preserving the stability of bond prices, the Fed has inadvertently defended poor behavior. For some, the Fed’s active approach creates a “moral hazard” problem: the Fed’s actions reduced the disincentive for risky lending. Shouldn’t the original investors bear the full damage for their poor decisions? Why, for example, should taxpayers bail out AIG after their own investment team crippled the company?
After the collapse of Lehman Brothers, the Federal Reserve felt that a company’s collapse can have disproportionate effects to the rest of economy. Federal Reserve chief Bernanke argued that the damage would be too widespread to fully contain. He described this analogy:
“If you have a neighbor who smokes in bed, he is a risk to everybody. And suppose he sets fire to his house. You might say to yourself, ‘I’m not going to call the fire department - let his house burn down – it’s fine with me.’ But then, of course, what if your house is made of wood and it is right next door to his house? What if the whole town is made of wood? I think that we’d all agree that we should put out that fire first, and then say: ‘What punishment is appropriate? What should be done to make sure this doesn’t happen in the future?’”
Several years into the recovery, the Federal Reserve has not stopped using unconventional tactics to manipulate the market. Quantitative easing program 2 (QE2) started in 2010 and enabled the purchase of another $600 billion in long term US Treasuries. In 2011’s Operation Twist, the Fed sold $400 billion short-term treasuries to purchase longer-term treasuries. Why did they do this? In brief, long term bond rates affect long term mortgage rates. Purchasing long term bonds puts pressure on long term interest rates, and that provides additional support to a still-weak housing market. (Low long-term rates make mortgage programs more affordable.) On the other hand, critics charge that these artificial manipulations prevent an organic recovery in the housing market.
A more recent example: the Federal Reserve is now signaling that it intends to keep interest rates unchanged until late 2014. Why? The Federal Reserve may feel that the worry of imminently rising interest rates could frighten equity investors. (When rates go up, equity markets tend to fall.) The Fed may also be signaling that it will take whatever actions necessary, conventional or otherwise, to bolster the recovery. On the other hand, critics (such as JP Morgan’s Brian Kelly) argue that the multi-year, low-rate declarations are a mistake. With interest rates low, the cost of getting credit is “cheap”. So, if investors know that have a two year window to get cheap credit, there isn’t an immediate incentive to get it (and use the money to invest in a business, open a new shop, get a car loan, etc.). Investors now know they have several years to delay before locking in cheap financing. Worse, when the Fed says that it’s going to keep rates low for 3 years, it is implicitly saying that the economy is going to be terrible for 3 years. That doesn’t give much room for hope or confidence.
Still, the backlash against an activist Federal Reserve has been unusually harsh. From the left, there is a criticism against an institution that props up a failed financial sector while guiltless taxpayers become unjustifiably exposed to additional risk. Meanwhile, ordinary consumers continue to suffer the direct affects of the recession and housing crisis (underwater mortgages, foreclosures). From the right, the ongoing GOP primary has revealed a great wariness about the unchecked spending powers of an unaudited government institution. Some candidates scold the Fed for emphasizing its low-unemployment mandate at the potential risk for high inflation in the future. Former GOP candidate Rick Perry put it colorfully:
“If this guy [Ben Bernanke] prints more money between now and the election, I don’t know what you all would do to him in Iowa, but we would treat him pretty ugly down in Texas. Printing more money to play politics at this particular time in American history is almost treacherous – or treasonous - in my opinion... All it’s going to be doing is devaluing the dollar.”
To the Fed’s credit, core inflation measures have actually been fairly contained since 2007. Future inflation projections from other financial institutions are also quite tame. This suggests that the Fed’s actions, however aggressive, have appropriately offset the deflationary tendencies of a severe economic crisis. Still – investors worry that the Fed just won’t be able to soak up the excess liquidity fast enough to rein in future inflation. That fear is easily gauged by the explosive increase in hard asset prices - like gold; gold prices have more than doubled since the financial crisis. Investors expect hard assets to retain buying power while paper currency depreciates.
How is the Fed responding to the pressure?
The decision making process at the Fed has been always been unclear to outsiders, and that obscurity breeds suspicion. A decade ago, market watchers used to monitor the size of Alan Greenspan’s briefcase on his way to congressional meetings to predict interest rate policy. (A larger briefcase suggested that he was bringing additional data to the meeting, portending a change in interest rates.) Two years ago, analysts would carefully parse Federal Open Market Committee (FOMC) official statements for significant changes to word selection. Removal of the phrase “extended period” from these statements, for example, would be taken as a signal for future rate increases. Analysts had to interpret how much worse a “modest” growth estimate is compared to a “moderate” growth estimate.
In January 2012, the Fed announced great changes in its communications policy. With distrust – arguably - at an all time high, the Fed now promises to make the meetings of the FOMC significantly more transparent. Rather than having to guess at the machinations of an opaque and misunderstood body, the projections and recommendations of the 17 policy makers will become open.
For example, on January 25th, the Fed disclosed the results and analysis of voting FOMC members for the newest rate statement. Market analysts can now note that 3 members preferred 2013 as the appropriate policy-firming target date, and 5 FOMC members preferred 2014 instead. (Individual policy makers are not identified yet.) Better, the various numeric analyses from different members will be available. The hope is that the greater transparency will improve the trust and understanding between policy makers and the public. With greater disclosures, the difficult mission of the Fed may be shielded from excessive criticism, and its independence preserved.
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