The Fed in a Corner

Over the years, I have warned a seemingly countless number of undergraduates that Fed’s hold on monetary independence was tenuous at best. Independence is not guaranteed by the Constitution. Congress made the Fed, and Congress can unmake the Fed. The Fed could only maintain the privilege of independence if policymakers pursued policy paths that fostered maximum, sustainable growth. Deviating from such paths would have consequences.

The Fed is quickly learning the extent of those consequences, as Congress launches an assault on the Fed’s independence.

Some find the loss of support for the Fed puzzling. Brad DeLong, for example, notes that Bernanke & Co. are doing exactly what they should have done:

First of all, from the day after the collapse of Lehman Brothers, the policies followed by the U.S. Treasury and the U.S. Federal Reserve and the U.S. administrations have been very helpful. They have been good ones. The alternative–standing back and watching the markets deal with the situation–would have gotten us a much higher unemployment rate than we have now. Credit easing by the Fed and support of the banking system by the Fed and the Treasury have significantly helped the economy: have kept things from getting much worse.

The Fed earns accolades from academics for its handling of the crisis, in particular since the Lehman failure. Fair enough; I have few quibbles with policy since last fall. But what about the years before Lehman, when the crisis was building? Where was the Fed then? Did they abdicate regulatory responsibility? How did banks develop such incredible exposure to off-balance sheet SIV’s? How could the Fed ignore increasingly predatory lending in the mortgage market? What exactly was Timothy Geithner, then president of the all important New York Fed, regulating and supervising? Clearly not Citibank.

To be sure, there were plenty of other regulatory failures along the way, but the Fed – an independent Fed – should have been in a much better position to raise regulatory and supervisory roadblocks during the debt build-up compared to other, more politically susceptible agencies. The Fed’s independence should have allowed it to be a leader, not a follower. Ideological objections to regulation, apparently, prevented the Fed from looking for problems in their own backyard. Rapid debt creation was justified as a response to asset appreciation, with little concern that the connection might just be a bit more self-reinforcing.

The resulting crisis left the Fed struggling to keep the ship afloat – and in that struggle the Fed stepped too deep into the realm of fiscal policy in an effort to keep the trains running on time. But that mission creep was simply incompatible with the Fed’s desire for secrecy. This was all to predictable: Like it or not, you cannot commit literally billions of dollars of taxpayer money and in the process secretly funnel money through AIG to the investment banking community without expecting just a little blowback. The last I checked, this was still a democracy.

Worse now for the Fed is the impression that monetary authorities work first and foremost for Wall Street. Of course, Fed officials see this a bit differently – they see supporting Wall Street as their mechanism for supporting Main Street. Ultimately, without the former, the latter is locked out of capital markets, and economic chaos follows. The purpose of Wall Street is supposed to be to channel investment funds into Main Street. But most Americans no longer view Wall Street as ultimately working in their best interests – maybe correctly. This is the same Wall Street that aggressively pushed garbage loans onto the American people as policymakers praised the wonders of financial innovation. When did the purpose of finance evolve into simply a mechanism to enrich the relative few at the expense of many? And when did policymakers embrace this view? As Paul Krugman has noted, the Fed cannot envision a world not dominated by the magic of structured finance. Yet this is a world tht failed us to completely.

Ultimately, can you really blame Americans if they have lost their faith in the supposedly omnipotent Federal Reserve?

Now the Fed’s relationship with the public is a mess. And I suspect it is going to get much worse. Free Exchange succinctly identifies the new challenge:

An independent central bank is crucial. Political control of monetary policy must inevitably lead to accelerating inflation and long-run economic instability. But at the moment, the American economy could use an increase in expected inflation. And a real threat to Fed independence would almost certainly deliver it, either because markets would anticipate increased political influence on monetary policy ever after, or because the Fed would seek to fend off pressure from Congress by easing further, which amounts to the same thing. But we don’t actually want there to be a real threat to Fed independence, because that way uncontrolled inflation lies.

The Fed has made it clear that unemployment is expected to remain unacceptable high in the medium run while disinflationary pressures persist. Yet policymakers have also made it clear that they believe they have done all they can, or are willing, to do to combat unemployment. They equate credibility with maintaining a 1.7-2% inflation target. Couldn’t credibility be consistent with a 4% inflation target? And wouldn’t such a target be more appropriate in a zero interest rate world? But alas, challenging the Fed now with their independence at stake will only convince policymakers to dig in their heels more aggressively.

What if the only way to get the Fed to do the right thing is to strip them of their independence? It is a real possibility, although disastrous in the long-run. Yet look at the dithering from the Bank of Japan, still faced with a deflationary environment years and years after they pushed to zero rates:

It was no coincidence that the new government of Yukio Hatoyama chose the day when the Bank of Japan (BoJ) was holding a rate-setting meeting to make a lot of noise on the issue. Both the deputy prime minister and finance minister made concerned comments. Their unspoken message to the BoJ was clear: remove monetary-stimulus measures at your peril. At the end of its two-day meeting, the BoJ left its policy rate unchanged at 0.1%, and continued to use other measures, such as buying government bonds, that it believes make monetary policy “extremely accommodative.”

But the BoJ does not give the impression it is particularly concerned about prices. It believes there are not yet clear signals of a deflationary mindset in corporations or the public at large, and that a recovery in private demand will eventually pull the economy out of its slump.

Good Lord, we have been talking about pulling Japan out of its slump for TWO DECADES! Fear of inflation combined with a perception that acquiescing to a higher inflation target would be akin to losing monetary independence has kept BoJ policy constrained for years, ensuring the citizens of Japan ongoing pain. Is the Fed headed to the same place? Maybe.

I don’t think the Fed can regain the trust of the public while at the same time protecting the secrecy of their actions to save Wall Street (moreover, it is not clear that such secrecy is now needed in any event). The relationship between policymakers and financiers is now seen as far too cozy from the perspective of the public. I think the Fed needs to make clear that they work for the people, not for Wall Street. A strong statement by Federal Reserve Chairman Ben Bernanke that a firm that is too big too fail is simply too big – that we should no longer tolerate the expansion of financial firms to the point that they pose systemic risk – would be a good start. Simply put, Bernanke’s choice set is dwindling – either risk losing independence, or step up to the regulatory and policy plate like you intend to hit one out of the park. If Wall Street is no longer working for Main Street, it is time to side with Main Street.

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