The Fed That Should Be
One of my correspondents was asking me what the heck is going on at the Fed, The Federal Reserve System that manages monetary policy for the United States. That is not only a good question, it’s an important question because, while Fed policy may not affect you on a daily basis, it does affect your 401(k) on a daily basis. The stock market is bonkers on figuring out what Fed policy actually is. Analysts comb Fed communications for meaning and nuance. The change of a single word in their statements issued after Federal Open Market Committee (FOMC) meetings can send the market up or down by hundreds of points.
Perversely, good news (such as a strong increase in GDP and continued low employment) can send the stock market into the tank because analysts interpret news in light of how the Fed will react to the news. Strong economic growth and low unemployment are believed to motivate the Fed to keep interest rates high to tame inflation. Bad news sends the market skyward as analysts hope that the news will cause the Fed to pivot and ease monetary policy.
It shouldn’t be this way. The stock market should reflect the prospects of the underlying economy and how that will affect the companies listed on the exchange, not hang on every little nuance and rumor that slips out of the Fed. I blame it on John Maynard Keynes. Everybody at the Fed has become a Keynesian. It’s not their fault. Congress forced them to become Keynesians when they passed the Humphrey-Hawkins Full Employment Act in 1978 that saddled the Fed with a dual mandate. The Fed is mandated to maintain monetary stability (in other words low inflation) and full employment.
Keynes’s General Theory is the opioid of economics. Intended to give government a tool to help manage the economy, the General Theory has been abused just like opioid medicines. And it is just as addictive as opioids, as well. Keynes’s theory suggests that government spending can stimulate demand which will increase economic growth and reduce unemployment. If this government spending occurs during a recession when tax revenue is down, the spending will result in a deficit. Telling a politician that increasing government spending will goose the economy, reduce unemployment and make him look like a hero come election time, makes the politicians’ eyes light up like a drug addict’s when the first surge of heroin hits their blood stream. Politicians tend to ignore the second half of Keynes’s theory where he said that after the recession was over the government should structure the budget to produce a surplus in order to avoid overheating the economy which could cause higher inflation. That surplus could then be used to repay any indebtedness that occurred as a result of the deficit. But the addictiveness of deficit spending has our politicians firmly in its grip. The US has had a surplus in only four years since 1970.
Humphrey-Hawkins converted all the bankers at the Fed into Keynesians, and these Keynesian central bankers are “activist” central bankers. They believe the mantra that public intervention can increase consumer demand and spur economic growth that will in turn increase employment even though such economic growth and the increased demand for labor can create inflation. Low interest rates and rapid growth in the money supply are the tools the Fed used to goose the economy and increase the demand for labor in order to recover from the shock of the Covid pandemic’s impact on the economy.
In response to the Covid pandemic the Fed had dropped the Fed Funds Rate to essentially zero. The Fed Funds Rate is the rate which banks trade reserves at the Fed amongst themselves. The Fed maintains the rate through its open market operations. After inflation surged to record levels in 2022, the Fed began to raise the Feds Funds rate. The target Fed Funds Rate is now set between 4.50% and 4.75%. But the Fed had maintained a regime of very low rates for most of the last fifteen years, long before Covid. Rates so low that the real Fed Funds Rate which takes into account the impact inflation has been negative for most of that time.
Emergency measures passed by Congress to counteract the impact of Covid increased the M1 money supply over 400 percent by handing out checks and transferring money to everyone in the country. M1 increased from around $4 trillion to over $16 trillion in just a few months. But the money supply continued to increase by another $4 trillion over the next year.
We can understand increasing the money supply in an emergency such as a pandemic, but the Keynesians at the Fed had increased the money supply at a rate of 9.0% per annum for a decade (compared to only around four percent in the previous decade).
The Treasury paid for the Covid emergency payments by issuing public debt. Much of that debt was purchased by the Federal Reserve in a process called quantitative easing or QE. Because the Fed cannot purchase Treasury Bonds directly from the Treasury, it purchased bonds from investors on the open market by crediting their bank accounts. Fed assets jumped from $4 trillion prior to the onset of the pandemic to over $7 trillion in the months afterward and kept increasing to around $ 9 trillion as the pandemic held the country (and the world) in its grip. But the Fed’s balance sheet had been less than $1 trillion as recently as 2008 and had increased as a result of the Great Recession but had continued to increase long after the end of that recession.
From a financial perspective our country had been greatly weakened by the Keynesians’ desperate attempt to goose the economy and lower unemployment, Covid only further weakened our already debilitated financial situation. The public debt soared from around $10 trillion in 2008 to around $30 trillion now. Our unfunded future obligations are many tens of trillions of dollars more. America was already addicted to the opioid of quantitative easing and low interest rates long before it got whacked by Covid.
America is full of institutions and associations that are dedicated to the promotion of certain ideas or the interest of certain groups. The UAW is dedicated to the promotion of the welfare of its auto worker members. The American Cancer Society is dedicated to the eradication of cancer in our country. The National Rifle Association is dedicated to the promotion of gun safety and gun rights. Each of these groups is successful to the extent that it can promote its specific interests. Their ability to achieve their goals is primarily based on their ability to focus on one specific goal where they have specific knowledge or abilities that the rest of the population lack. If they were required to attempt to achieve other goals outside their expertise they would not only be ineffective at achieving those extraneous goals but would also be impaired in achieving their dedicated goals.
Central banks, like the Fed, are good at some things and not so good at other things outside their expertise. They are pretty good at controlling the money supply, controlling the level of interest rates and protecting the integrity of the financial system. These are important functions that need to be done in any economic system. Central banks are not particularly good at goosing economic growth in the long term or lowering the unemployment rate.
The Humphrey-Hawkins bill was a bad idea that tried to extend the Fed’s responsibilities outside its areas of expertise and capabilities. Now the Biden administration wants to saddle the Fed with additional responsibilities that it has even less ability to affect. They want the Fed to require the financial system to enforce the environmental and social justice policies they support (even though the Fed has no experience or expertise in this area) in addition to its responsibilities of supporting the financial system (where they do have experience and expertise). This is madness.
Milton Friedman had a different opinion on what central banks should do. The finance and banking courses I studied in college (before the passage of Humphrey-Hawkins) assumed a very passive role for the Fed. The money supply should grow at a rate to accommodate the growth of the underlying economy, not at a faster rate in order to spur the economy. Friedman actually recommended that the Fed be replaced by a computer that would calculate all of the economic data and adjust the money supply accordingly. The Fed would continue to be responsible for the inter-bank rate of interest and the stability of the financial system as the lender of last resort. Tasks it is eminently qualified for and for which it was created. If the Fed was doing these tasks properly, hardly anyone would be aware of its existence. Wouldn’t that be a relief?
Instead of being the drug dealer for the Congress of the United States, we need to repeal Humphrey-Hawkins so that the Fed can focus on its primary responsibilities and not waste its efforts on unachievable political goals. The Fed’s expansive policies and burgeoning balance sheet have muted the price signals in the bond market thereby supporting the massive increase in public debt. Without Fed interference, investors would have communicated their thoughts about the public debt by demanding higher interest rates.
Right now, the market is freaking out about the 10-year Treasury bond yielding almost four percent, but investors are still losing money because the current inflation rate is around six and one-half percent. And a Fed Funds rate below five percent is also negative. Even if the Fed could reduce the rate of inflation to its target of two percent, the yield on the 10-year should be around four. And the Fed still would have a lot of work to get financial markets into a healthy state, but that’s its job.
If the Fed was truly independent and did its job, then it would fall to the politicians at both ends of the National Mall to get the country’s finances in order as well.