The Understatement of the Year


Growth Management Isn’t the Fed’s Forte

The stock-market turmoil is fresh evidence that the central bank must return to market-based monetary policy. …The Fed has fostered the illusion that it can create growth. The zero-rate problem is obvious to almost everyone outside the Beltway. Credit markets don’t function with prices set at zero, and the economic results have been disastrous, with median incomes severely depressed five years into the expansion.

By David Malpass

The Federal Reserve has been a crucial bulwark of America’s market economy. Yet with interest rates near zero since the 2008 financial crisis and the Fed now controlling huge swaths of the financial industry, a central-banking approach I call “post-monetarism” has settled in. It’s built on the absurd view that zero rates promote growth and that regulators can replace markets—an immodest dogma that has hammered growth.

In the past, the Fed set boundaries on the banking system mainly by adding and subtracting bank reserves. Banks made new loans if they had enough reserves on deposit at the Fed and thought the loan would be profitable. In the 1960s the eventual Nobel laureate and father of monetarism, Milton Friedman, linked steady growth in money and market-based pricing to faster economic growth.

Under post-monetarism, the Fed has created a massive excess of bank reserves, nearly $3 trillion, to fund its bondholdings. It counteracts the transmission into the economy using huge interest payments to banks and sweeping regulatory controls that have turned the Fed into a superpowerful fourth branch of government. That’s diametrically opposed to Friedman’s deeply American insight that a central bank, if it has to exist, should be modest, and that monetary policy should be predictable and simple enough that businesses concentrate on profits and employees rather than central bankers’ economic forecasts and speeches.

Financial markets have become giddy—but not the old-fashioned way, by sharing in the nation’s rising prosperity. This time, median incomes fell as financial markets rose. The Fed has imposed near-zero interest rates on small savers, channeling trillions of dollars in low-cost credit to Fed-selected beneficiaries, especially governments and large-scale corporate borrowers. The result is helpful for the rich but has been toxic to small businesses and median incomes because underpriced credit goes to well-established bond issuers—not known for job creation—at the expense of savers and small business loans.

The Fed has in effect become the king of banks, able to violate the liquidity, leverage, capitalization and regulatory standards imposed on private banks. America’s financial industry faces a morass of litigation, huge fees and arbitrary capital requirements when they step out of line, while the Fed has piled up a record maturity mismatch—risky short-term debt to fund long-term assets. The Fed’s debt has reached 78 times its equity capital.

The Fed is the kingmaker for the mortgage industry, where it has become one of the world’s biggest mortgage holders, building up the government-sponsored enterprises Fannie Mae and Freddie Mac at the expense of the private mortgage industry.

The Fed expanded into asset management with this summer’s announcement that, rather than downsizing its assets, it will roll over its expensive bank debt. This will channel as much as $1 trillion in maturing bonds into chosen government investments over the next five years. The Fed has said it doesn’t intend to sell any of its $1.7 trillion in mortgage securities, many of which don’t mature for nearly 30 years, which would make the Fed’s failed experiment in post-monetarism almost irreversible.

The Fed is also getting into insurance-industry regulation through rules created by the Financial Stability Oversight Council. That’s the new, immodestly named club of chief regulators, all Democratic appointees, which meets behind closed doors and outranks the old system of independent two-party regulatory commissions like the Securities and Exchange Commission and the Federal Deposit Insurance Corp.

The FSOC has tagged insurance giants Prudential , AIG and MetLife as systemically important financial institutions, or SIFIs, giving the Fed regulatory oversight over them. “Oversight” often means semipermanent on-site offices paid for by the regulated company with the government practicing unprecedented involvement in the business. An industry bulletin explains that government regulators may “attend board meetings including closed sessions” and may also attend the company’s internal risk committee meetings.

MetLife plans vigorous resistance in court to its SIFI designation and submission to the Federal Reserve. But companies are running into a Catch-22 as they appeal harmful regulatory actions: Many of the regulations from the incomprehensible 2010 Dodd-Frank financial law have yet to be written and therefore can’t be challenged.

The three branches of government are bound by the appropriations process and the articles of the Constitution that created them. Not so for the Fed, which has unfettered access to nearly $100 billion a year from its bond-market arbitrage. There are no limits on the size of the Fed’s balance sheet or the justifications for it.

A critical step in ending the U.S. savings-and-loan crisis in the early 1990s was the sale of the government’s portfolio so that the economy could move on. The 2008 financial crisis is long over, yet the emergency measures remain, leaving markets heavily distorted and economic growth historically weak for a post-recession “recovery.”

The Fed should stop, but it has instead become huge, intrusive and inbred, organizing monetary policy to avoid disrupting Wall Street and the well connected. Now, with global growth slowing again and the Dow Jones Industrial Average down more than 5% in the past month, the Fed is thinking the dosage—six years of near-zero rates and $4.5 trillion in Fed liabilities—may be too low. Fed Vice Chairman Stanley Fischer raised the prospect Saturday of treating slow growth by keeping interests rates near zero even longer.

The Fed has fostered the illusion that it can create growth. The zero-rate problem is obvious to almost everyone outside the Beltway. Credit markets don’t function with prices set at zero, and the economic results have been disastrous, with median incomes severely depressed five years into the expansion. Each month the Fed delays a return to market-based monetary policy compounds the financial distortions, sacrificing the investment and hiring needed to create faster growth.


Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s