Tag Archive for: FederalReserveActivism

A New Fed Report Holds a Clue on Why Banks Are Collapsing

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Estimated Reading Time: 3 minutes

Federal regulators seized the struggling First Republic Bank on Monday [5/1/23], which they promptly sold to JPMorgan Chase. Reports show First Republic had some $230 billion in financial assets which quickly evaporated, making it the second largest bank collapse in US history, exceeding the recent bankruptcies of Silicon Valley Bank and Signature Bank.

You read that correctly—three of the four largest bank collapses in US history have occurred in the last 60 days. The events naturally have raised questions about the strength and durability of the US banking system. As of Tuesday, confidence appeared weak. The KBW Regional Banking Index saw shares hit an annual low as investors fled from regional bank stocks.

That something is wrong in the US financial sector is apparent, but few agree on the source of the affliction. Some blame banks for going “woke”, while others point to Federal Reserve policies. Others call out the failure of regulators and bank auditors.

One possible cause for the financial reckoning has gone largely unnoticed, though it was buried in a Federal Reserve report published Friday.

While the conventional wisdom is that banks simply need to be regulated harder, a report from the Fed’s board of governors suggests banks are already struggling to navigate a labyrinth of federal rules and regulations. This was particularly true of SVB, which had experienced rapid growth in recent years, causing it to “move across categories of the Federal Reserve’s regulatory framework.”

That framework, the Fed dryly notes, “is quite complicated.” (Indeed.) And the report makes it clear that SVB was spending a lot of time and money on consultants trying to navigate this framework “to understand the rules and when they apply, including the implications of different evaluation criteria, historical and prospective transition periods, cliff effects, and complicated definitions.”

Ultimately, the Fed points the finger squarely at SVB in its postmortem, not government regulations.

“Silicon Valley Bank’s board of directors and management failed to manage their risks,” the report states. “Supervisors did not fully appreciate the extent of the vulnerabilities as Silicon Valley Bank grew in size and complexity.”

That SVB bears the most blame for its demise is true, as I’ve explained. But the Fed’s report sheds new light on why SVB wasn’t as focused on managing its risk as it should have been.

“It’s clear SVB found it challenging to deal with an overly complicated regulatory framework being pushed by the Fed, which included a new focus on climate change risk assessment and cultural issues, such as fairness and equity,” Stephen Dewwey, a retired federal financial regulator, tells me. “That is time and resources the bank could have spent analyzing interest rate risk and prudent management of its balance sheet.”

Although the Fed owns up to some of its own regulatory impotence during the collapse, it mostly passes the buck onto SVB. Worse, the central bank cites SVB’s collapse as a reason to give regulators more control over the financial system. This might sound ludicrous given the Fed’s recent failures, yet it’s precisely what we should expect.

“An iron law of the modern administrative state is that the solution to regulatory failure is always to give regulators more power,” the Wall Street Journal’s editorial page noted.

This phenomenon is what Austrian economist Ludwig von Mises described in his historic 1950 address “Middle-of-the-Road Policy Leads to Socialism.” Mises understood that not all countries adopt socialism through bloody revolutions. Some arrive there slowly, through a process he describes as “interventionism,” which is viewed as a middle way between “unbridled capitalism” and socialism.

The problem is, these interventions—price controls, labor standards, consumer protections, etc.—come with costs and often create market problems. When these problems arise, regulations rarely are lifted. On the contrary, the “free market” is often blamed, and more intervention is demanded.

“As a remedy for the undesirable effects of interventionism they ask for still more interventionism,” Mises observed. “They blame capitalism for the effects of the actions of governments which pursue an anti-capitalistic policy.”

This is precisely what is happening today with the banking crisis. Instead of blaming the government’s byzantine regulatory framework or the Fed’s monetary schemes—which no doubt are even more to blame—bureaucrats say they simply need more control.

*****
This article was published by FEE, Foundation for Economic Education and is reproduced with permission.

The Next Two FED Meetings Could Be Market Movers

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Estimated Reading Time: 4 minutes

There is little doubt today that what the Federal Reserve decides to do with both interest rates and its massive balance sheet is perhaps the most important variable moving markets.  The next two FED meetings loom as particularly important.  The key dates will be May 3rd-4th and June 14th-15th.

To be sure, corporate earnings, retail sales, real estate activity, industrial production, the world economy, politics, tax policy, and numerous other variables impact markets as well.  But nothing has been moving markets over the past 20 years quite like FED policy.

While economists and historians will no doubt continue to debate the efficacy of the central bank intervention, the fact is those of us with money in markets must deal with it.

Right now, we notice the chart action of many important markets are sitting on major inflection points.  An inflection point is defined as a market at either important overhead resistance or downside support.  Which way the FED goes could well push markets above resistance or below support, creating important signals in a variety of markets.

In the past month or so, the markets have been coming down in volatility into a kind of an eerie holding pattern, suggesting considerable confusion among market participants.

The stock market has been buoyant, recovering rather quickly from some staggeringly large bank failures. The stock market seems to be saying the nirvana of the soft landing is nearby and that the FED is likely done raising interest rates. 

The stock market seems to feel the FED has taken enough inflation out of the system, that the numbers are running in the right direction, and that they will as a result, will stop raising rates (pause), and then soon shift back to lower interest rate policy.

The FED itself has been saying otherwise, but the stock market seems to be saying, you are mostly talk and you will not push the economy to recession to fight inflation…  not with a major political cycle just ahead.

The stock market does also not seem particularly concerned with earnings reports or lofty valuations.  Some of the most expensive companies, many in technology, have taken over market leadership again.

But the bond market has been strong (lower rates) but recently started to reverse trend suggesting that the FED will continue to raise interest rates.  Not only is money again becoming more expensive, evidence suggests banks and other lenders are tightening up credit requirements after the surprise of large bank failures.  Not only is credit getting more expensive, it is getting harder to obtain.  Both developments are negative for the economy and hence indirectly negative for stocks.

One of the deans of technical analysis, the late Richard Russell, used to say that when the stock market and the bond market are discounting different scenarios, Russell advised one should believe the bond market.  His reasoning was that the bond market is by comparison much larger and is mostly a professional market.  The public may dabble in stock speculation, but professionals run the bond market.

If this observation holds, be prepared for the FED to raise rates one or two more times, creating the real risk of recession.  This will wind up being positive for bonds later, but negative for stocks in the near term.

Chart courtesy of stockcharts.com

Here we see the very important 30-year mortgage rate.  It has gone up a lot and is still double what it was just at the beginning of 2022.  This has put downward pressure on housing activity since the down payment is very much a function of both the house price and the cost of interest.  But like the bond market, recently rates have started back upward, suggesting the FED is not yet done raising rates.

Other markets as well are trying to peer into the future and divine what the economy and the FED are going to do. As mentioned, many of these markets are also at important inflection points.

The gold market has moved nicely to levels above $2,000 per ounce and will either break out, or once again, fail to move higher.  Has gold stalled out or is it just gathering strength for a push to all time new highs?

Silver has moved up to a long term trendline formed by the peak in prices at near $50 per ounce a number of years ago.  It too could either break out or fail.

The US dollar has formed a large head a shoulder looking pattern with important downside support at 100 on the US dollar index.  It either holds, or it folds.  A weaker dollar suggests lower interest rates, while a stronger dollar suggests the opposite.

Chart courtesy of stockcharts.com

Two of the more interesting charts are copper and lumber, both sensitive to economic growth.

Chart courtesy of stockcharts.com

Copper has been in downtrend for more than a year.  It will either continue to fall, or gain enough strength to reverse its bear trend.  The weakness is somewhat surprising given the widespread belief in the future of electric vehicles and the need to re-tool the entire electrical grid.  Why the weakness?  Maybe copper is telling us the economy is slowing, which would not be good for the stock market. It seems to agree more with the bond market than the stock market.

Chart courtesy of stockcharts.com

Lumber prices are a key indicator of demand for housing construction and it too has been in a bear trend.  But like copper, it would not take much upside action to reverse trend.  But again, right now, lumber seems to be saying demand is soft and so is the economy.

We have real issues with the FED.  Central planning has a terrible track record as bureaucrats, absent real world free markets, can’t really know what the “proper” interest rate should be or the supply of money.

The FED largely controls the demand side of the ledger by creating money, or claims on goods.  But the FED itself can’t produce the goods, the commodities, or the structures they are creating demand for.  Hence, even if they are the best guessers in the world, they only have half the equation.

Despite what the FED likes to say, they are also a highly political organization.  Afterall, most of the governors voting on policy are nominated by the President and hence, have either loyalty to the abstraction of neutrality or reality of politics.  And guess what, we are getting very near to the next political cycle.

Inducing a recession would be highly unpopular.

But letting inflation run longer and hotter would also politically problematical.

The FED now has the markets trained to react to every decision and every rhetorical nuance.

They are now a little like the dog that finally caught the car.  Having been successful, now what does the dog want to do?

Can Markets Function Normally With Intrusive Central Planning?

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Estimated Reading Time: 6 minutes

Editors’ Note:  On Friday, March 10, Silicon Valley Bank collapsed, the second largest bank failure in US history.  There is common wisdom that the FED keeps raising rates “until something breaks.”  There is likely no bigger single market intervention than the manipulation of interest rates. Along with the meltdown in cryptocurrencies, their banks, and exchanges, pension funds in the UK; this is the first really large banking failure.  Officials in 2007-2008 suggested banking troubles were “isolated events”, but history proved later that was not correct.  It will be very important to see how far the rot has spread in our financial system.  Most all banks that own long-dated US Treasuries and mortgage-backed securities are taking large losses because of the FED sharply raising rates. These events illustrate the problem the FED must deal with.  Having blown a huge financial bubble with cheap money, they must now deflate the bubble, but at the same time hope they can avoid the collateral damage that could plunge the economy into recession.  If they back off too early, they lose the inflation fight.  If they persist too long, they risk a recession.  Trying to thread the policy needle just right represents a substantial risk to the financial markets.

 

As readers may be aware of our past stock market commentaries, the stock market is at an important juncture.  After last year’s bear market of a bit better than 20%, stocks started to rebound this year.

Historically, it is normal for the third year of a Presidential term to be bullish.

A rally from the worst of Covid-related economic trauma would also be expected.

The market seems to be going through a series of conflicting mental states:  the economy will have a soft landing, the economy will have no landing at all, and recently, the economy will have a hard landing.

The recent rebound created internal strength and momentum sufficient that it has convinced a fair number of commentators, mostly of a technical stripe, that a new bull market in equities has begun. In their defense, the market did break its bear linear trend line and turn up major moving averages. It has a high number of “breadth thrusts”, high volume days where advancing issues swamp declining issues. So, it is indisputable that the market is acting better.


Curtesy of stockcharts.com

Oddly though, after the “break out” the market decided to confuse everyone even further by diving back to the breakout point and then fiddling around in narrow a range as we write. In part, this was because of Congressional testimony by FED Chairman Jerome Powell, who expressed a “higher for longer” position on interest rates.

Is it a new bull market or a bear market rally?  Our best estimate has been that it is a bear market rally. Given the retreat back down to resistance we would have to say, the “break out” remains unresolved and thus a trend in force remains in force until proven otherwise. The trend in force has been a bearish downward trend.

We suggested this is a bear market rally based on the “weight of the evidence,” both fundamental and technical, although we frankly thought the market advance would last a bit longer than it did. Did Powell kill the baby in the crib?

The technical strength remains impressive. Even after more talk of higher interest rates, the market has refused to cave in. Instead, it fell right back to the resistance area, but so far has held…barely. However, it is fair to say that conditions are so fluid right now, it is probably best to avoid dogmatism.

For those of a more fundamental view, their concerns include the likelihood of a recession caused by rising interest rates, an inversion of interest rates, a decline in corporate earnings,  a housing slump, a historic decline in the money supply, and increasingly stressed consumers. On the positive side, employment remains buoyant and unemployment is at very low levels.

It is also historically rare for a major bull market to begin with valuation levels still as high as they are. There has been a bear market for sure, but it is far short of the “average” bear market loss of 36% and given the credit excesses and valuation excesses of this Supercycle, it would seem a bit odd to end this affair with such a modest correction.

The technical analysts counter this with an important argument. The very nature of their system posits that all known factors are incorporated into the price structure. In other words, all the worries about recession and interest rates, and concerns about earnings and whatever, are known, and still, the market has decided it still wants to rise.

If we are all talking about these troublesome issues, they are known. If they are known, the market is already incorporating that in the price structure.

Since we use both technical and fundamental analysis in our own thinking, we do not have an ax to grind for either school of thought. Both are valid ways of making judgments about the market. Neither is perfect so the more supporting information you have, from either camp, the better your odds of making a correct decision.

The deeper question is whether either school of analysis can function well in an environment of heavy-handed central planning that is driven by a political agenda.

It has become obvious that some of the “data” that fundamentalists use are altered by government policy and the FED itself. Greater government benefits and societal changes have made it possible for something on the order of seven million men of prime age to disappear from the labor market. That does make the labor market look tighter than it otherwise would be.

Central planning supposedly involves a degree of secrecy, otherwise, those who know what policy shifts will occur can profit. However, it is amazing the number of congressmen and congresswomen, and even FED officials who have speculated on stocks given their privileged position to get inside information first. It would appear that ethics is no match for the self-interest of bureaucrats and politicians.

It can be argued that if that is the case, then the market does have information because buying or selling activity is occurring, spreading the information.

But how far must information be dispersed before markets get a true reading of demand? Nancy Pelosi herself should not be able to move markets, even if she and her husband may trade on inside information.

The theory of central planning also assumes there is a central plan. What if the FED simply makes things up as they go along, caves into political pressure, or is immersed in internal conflict that makes the mission less certain? The same can be said for the Biden Administration.

More frightening, what if they don’t know what they are doing yet are conducting a grand monetary experiment with Quantitative Easing, Quantitative Tightening, and Modern Monetary Theory?

We have never been in a situation where we are spending and borrowing on a scale of World War II, all in peacetime, and all on top of preexisting huge debt. There are scant historical examples to guide us through our current predicament. We are in a new historical territory almost every day.

You can readily see it is hard for markets to incorporate information into the price structure when there is little rhyme or reason to what central planners are doing. Improvisation of policy is difficult to discount unless you know what the whims of the prince will be. But if it was planned, it wouldn’t be a whim, would it?

Markets today may in fact be more like a gambling casino changing rules frequently based on the whim of the mob boss. If so, how well can markets discount future events and trends?

We do have markets today that jump around frequently not only the statements of officials in various venues, but also we have politically manufactured data that frequently get “revised.” Unless one has advance notice of what these spokesmen will be saying, it is pretty much a guess as to what they will be saying. The next guess is how will the market react to the latest statement.

Readers might recall the fall and winter of 2018 when the FED said they would raise interest rates.  As soon as the markets began to correct, the FED immediately changed course. It was a monumental whipsaw for investors and under these circumstances, it seems difficult for markets to incorporate such fluid decision-making into the price structure.

Our point is that central planning today is more like planned chaos and is not often conducted either with consistent political or economic principles and is driven by pollsters.

Such conditions argue for intellectual modesty regarding a new direction for the market.

Finally, there is the problem central planning has always had. It relies little on market data and more on political whim. Because it does not rely on true supply and demand, central planning has never worked. You cannot make rational economic calculations absent true free market forces.

It is an open question as to how well markets can truly function in today’s era of central planning.

Markets must deal not with just what direction the economy may be going, but more often, with what direction intrusive government policy is going.

The FED is moving interest rates, the government is selling oil from the Strategic Petroleum Reserve, NATO is sanctioning Russian oil, government skews lending to diversity and equity, economic growth takes a back seat to environmental zealotry, and there is a general regulatory jihad against business in general. Recently, Treasury Secretary Yellen says she now believes “climate change” can alter the value of securities.

How good are our tools of analysis, technical and fundamental, under circumstances of constant and incessant interference by the government?

Probably not as good as we would like them to be.

Amidst all this, we accept the primacy of the dictum of “don’t fight the FED.” Right now, the markets seem like they want to fight the FED. Because of that, we prefer caution. Eventually, the markets will get a better sense of direction when we are closer to the end of this interest rate hiking cycle. We will find out if we indeed have had a breakout or a head fake.

The Fed’s Takeover Of American Money And Energy Must Be Stopped

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Estimated Reading Time: 3 minutes

A pilot exercise in Federal Reserve Board social control of energy choices has been announced for 2023. The exercise will start with the government-crony Fed publishing climate scenario narratives.

Six mega-banks will take these ideologues’ narratives, supposing that climate-related financial risks exist. Using these narratives, the banks will practice deciding who to create money for and lend it to, and who to refuse to create money for and lend it to. Banks are the tools that the Fed uses to create money, producing inflation. Almost all the money that gets created gets created by banks; and all of that created money gets lent out by the banks.

The Fed will review the banks’ “analyses” and “engage with” the banks to build up their capacity to exercise this control. The Fed may publish publicly-available “insights,” but will remove information that would identify the banks and the targets of the Fed and banks’ control.

This exercise calls to mind the October 18, 2019 pandemic exercise Event 201. The simulation yielded several strong recommendations. In a pandemic, taxpayers should fund and governments should stockpile and control vaccines, therapeutics, and diagnostics. It was also found that governments should curb mis- and disinformation. Governments followed this playbook exactly during the 2020-2022 COVID-19 pandemic.

The Fed’s planned 2023 exercise isn’t innocent and isn’t advisory — it’s control.

Keep in mind that government bureaucrats are not consultants who can be hired or fired. Progressives have exploited this vulnerability to create permanent bureaucrats who stand in our way and don’t leave us alone until we pay off them and their cronies.

This administrative state has transitioned beyond formal rulemaking, issuing guidance to menace us and often leaving us guessing. For instance, the first director of the Consumer Financial Protection Bureau, Richard Cordray, said that the bureau wouldn’t issue any regulations defining exactly what actions or practices violate the bureau’s law. During COVID, health bureaucrats issued guidelines, which many state and local officials and other organizations enforced as law.

Such in-your-face coercion is making people start paying closer attention.

People realize that agencies like the FBI and government-chartered cartels such as the Fed, are like Chekhov’s gun — give them such power and they will soon use it.

People have yet to grasp that the existence of government monopolies doesn’t mean these monopolies are necessary or even helpful. Such monopolies’ existence only shows that special interests got some politicians to grant them favors. Since then, no politicians have put an end to them.

In the case of the Fed, there is a solution. Government money manipulation is unnecessary. Private banks have in the past produced sound money, backed by 100% reserves. This meant that money had to be saved up before it could be lent; it couldn’t just be created out of thin air. Private money producers can do this again, producing value-conserving, constant-quantity gold money, or, ultimately, productive equity-based money.

Removing Fed socialism will remove the bank’s destabilizing stimuli and money inflation that have disincentivized individuals from saving and have brought more serious crises. Removing fractional reserves will eliminate the crises seen throughout the USA’s past because of unconstitutional fractional reserves — under the various precious metals standards and post-1971 paper money.

With the Fed swept into the dustbin of history, massive problems will no longer be denied or kicked down the road:

  • Current total government spending of 38% of GDP (versus, through 1913, just 4% to 8% of GNP, and in the American Colonies just 1% to 2% of GNP) will no longer be possible by borrowing on future taxpayers’ back. Instead, constitutionally backing off, by honorably refusing to execute the unconstitutional administrative state and repealing it, will free individuals.
  • Retirement income-support and medical payments will no longer have their contracted-on purchasing power stealthily eroded by Fed inflation. Instead, outgrowing entitlements will further free individuals.
  • Government debts, which Progressive politicians have foisted on individuals, needn’t be left in place, leaving never-ending interest payments for the taxpayer. Instead, repudiation could — and should — end this shakedown. Future creditors would then shy away, further limiting the government’s ability to borrow more.

Governments can’t know as much as individuals know. Governments can’t act in individuals’ best interests as well as individuals can. Governments can’t control as many actions as individuals control.

Governments operate through force. They can’t add value. Governments can only take more of our wealth and block us from creating more.

The best way to change governments is quickly and extensively. Push that bully out of the way, and build ourselves up to keep him out of the way.

The Fed can’t fix the climate. The Fed can’t even stop itself from enabling government growth and from enabling bank lending to problematic cronies, even including customer-shunned, living-dead zombie companies. One Great Depression and two Great Inflations are more than enough already.

We will take care of our own business much better by ourselves.

*****
This article was published by The Daily Caller and is reproduced with permission.

Economic Truths, Perennially Forgotten

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Estimated Reading Time: 7 minutes

In 2021, Treasury Secretary Janet Yellen assured Americans that recent inflation was “transitory.” Back in 2017, Yellen, then Chairman of the Federal Reserve Board, hinted there would not be another financial crisis “in our lifetimes.”

Maybe she got that idea from Morgan Stanley boss James Gorman, who in 2013 put the chance of a crisis “in our lifetime” as “close to zero” as he could imagine. Well, imagination, as the song says, is crazy. “Your whole perspective gets hazy.”

These two experts, as Alex J. Pollock and Howard B. Adler tell us in Surprised Again! The Covid Crisis and the New Market Bubble, are far from alone. Economic experts, they confirm, have a collective accuracy that would embarrass a busload of blind golfers. Not one expert, they remind us, saw the Great Depression coming. And none foresaw the Calamitous Coronadoom Panic of 2020. Which lasted until now.

What is fascinating is that being wrong in no way dents the awesome armor of assurance donned by our experts. Whatever they do when given power, they do it boldly and without doubt. Whether this lack of humility is caused by amnesia or hubris can be debated. But no one can doubt  the astonishing effects of the economic “solutions” foisted upon us by a string of experts during the panic, each trying to correct the ill effects of the other “solutions.”

Pollock and Adler take us through it all: From the Covid lockdowns to the Fed printing money with glee; from the resultant market swings to the rush and retreat from cryptocurrencies; from the run in the housing market to crushing municipal debt and its ill effects on pension funds; from ballooning student loan debt to—again—the banks and the Fed.

This book serves as an excellent introduction to modern economics and monetary policy, presenting it cleaner than in any textbook, and with a complete absence of pedantry. Theory is backed by observation in a wonderful sort of Appendix (my favorite part) at the book’s end, a mini spreadsheet where the reader can write down a handful of indices when reading and compare them with history and with the authors’ predictions (also printed there).

Primarily, this is a book in which we re-learn the ancient truth that much of what we have learned will be forgotten in the next crisis. One perennially lost lesson, even though it’s been verified by history time and again, is that panic kills, both in the literal and figurative sense. This is not a book about public health, though. Pollock and Adler accept medical (what passed for ) “solutions” as a given, and only question economic “solutions.”

Take the catastrophic effects of lockdowns. The Dow was hovering around 29,000 when the Coronadoom panic hit. Then the government caused record unemployment by forcing many out of work  for “two weeks” to “flatten the curve.” The Dow then plunged by about 10,000 points. The same kind of thing with the NASDAQ, and with other market indices around the world. GDP dropped ten percent.

People rushed to cash and caused “an inability of market makers to efficiently handle trades.” Bonds, collateralized loan obligations, and other similar instruments were smacked hard. Tax revenue dropped, and municipalities that received income from airports, stadiums, and the like suffered, putting great pressure on public pension funds. Commercial real estate, like malls and retail rentals, felt deep pain.

Things weren’t all down, down, down. One thing that went up was residential mortgage delinquencies. And, eventually, inflation. That went way up.

Inflation was triggered, mainly, by the Fed’s printing spree, which, our authors tell us, happened because they followed the advice of Walter Bagehot, who had argued “central banks should lend early and freely” during crises to quell fear. And this advice worked. Sort of. “The short-term effects of the federal programs were beneficial; the longer-term financial impacts raise profound concerns,” the authors tell us. It is those profound concerns that interest us most.

The panic, in economic terms, is a story of the creeping tendrils of government insinuating themselves into every available crevice. The style and motive of government beneficence in the panic puts one in mind of Mr. Potter from It’s A Wonderful Life. Like our rulers, Mr. Potter guaranteed his bank sufficient funds to remain open during a run. The side effect was that, after the panic ended, he was left in control of the bank.

What about our panic—and future panics? Given the almost routine occurrence of economic panics, should the government make it known they will guarantee banks, loans, and other monetary investments? “Or,” the authors asked, “should the government promise never to make any future interventions, in order to force the market to price in all the risk?” In other words, make people act and accept responsibility for their actions. “Who would believe that promise? We wouldn’t. Would you, Candid Reader?”

If you did believe, it would, as the saying goes, be the triumph of hope over experience.

One thing good about government is that it never lets a crisis go to waste, including those crises it created.

There isn’t space here to discuss every aspect of the panic our authors tackle. But one of the most relevant is cryptocurrencies. At the start of the panic, Bitcoin, the best known and therefore most viable faith-based currency, was about one per $10,000. Like with other markets, the panic led to a sell off, and the price dropped almost in half.

Over 2021, after government interventions and the partial return of calm, it blasted off, making it to over $63,000 in April 2021. There was a sell off later that summer, then another rally followed by a long, steady decline. As of the end of August 2022, it’s around $20,000.

Will it fall to its pre-panic level? Stay steady? Shoot up again? If I knew, I’d invest. But I’d be skeptical, and, like our authors, am prepared to be surprised.

There are solid reasons for skepticism. One is the rise of competing cryptos, which give other outlets for those seeking escape from fiat currencies. Yet the confusion and uncertainty in their proliferation limits acceptance. Another concern is growing regulation. China forbids Bitcoin. What if more governments ban Bitcoin? They are surely considering it, because crypto is something they can’t control.

Facebook’s attempt to create its own coin is telling. They first called it Libra—get it? Then, after their aspirations smacked into government suspicion, they called it Diem. The blows kept coming. Finally, they called it nothing.

They had meant Libra to be a stable, worldwide form of money, controlled in some vague way by an international board, convened by Facebook, and based in Switzerland (which, of course, isn’t the United States). Finance ministers from the G-7, the Bank of England, Reserve Bank of Australia, and others all wondered out loud how they were going to get a piece of the regulatory action. After that, Facebook gave up.

Government did not, however. The lure of paperless money, with its attractive regulatory possibilities, was and is too strong. So governments set out to create their own crypto-like currencies, a process under development in many nations, including the US and China.

The first thing to fix is volatility. Bitcoin price, as we saw, is far too touchy. Our authors give a brief history of the development of “stable coins,” instruments that do not, by their nature, share the volatility of the traditional (strange word here!) cryptos. Yet to make a coin stable turns out to mean, more or less, pegging it to some fiat currency. Doing so turns the coin into something very like a digital currency.

That is no problem for rulers because, hey, did you know criminals use unregulated crypto? Of course, the definition of what counts as “criminal” has only expanded in time and likely will continue to expand. Anyway, why would you use crypto? Do you have something to hide?

The Fed wrote a whitepaper on the pluses and minuses of a digital dollar as interest swelled in cryptocurrencies during the Coroandoom Panic. The digital dollar, for most of us, is already here, though not centrally controlled. Paper cash hasn’t been king for a long time. Starbucks, for instance, recently announced they soon won’t take cash.

A digital dollar is more than just bits in a computer at your bank. It’s all transactions tracked and watched over by experts in government. Our authors deadpan, “it would be tricky to balance protecting privacy with the need to maintain cybersecurity and prevent money laundering and other criminal activities.”

They summarize the story of cryptos using the Doctrine of Unexpected Consequences (they don’t call it this):

[O]ne of the surprises on the 2020s is that a libertarian revolt against central banks in the form of cryptocurrencies looks to be taken over by central banks and may well end up vastly increasing and centralizing bank and government power.

One thing good about government is that it takes what is now infamous advice to heart. It never lets a crisis go to waste, including those crises it created. For instance, during past crises and government cures, the number of FDIC-insured institutions went from about 17,000 in the 1980s, to about 7,500 in 2009-2012, to just under 5,000 during the covid panic. This allowed government (in which we include the Fed) to fully take over Fannie Mae, Freddie Mac, and Ginnie Mae, which our authors note together comprise about “69 percent of the total mortgage market.”

Even though housing prices were juiced by the panic, the Fed accelerated their mortgage security buys. This kept mortgage interest rates low, which caused housing prices to rise. And it caused the Fed to swell. In 2006, on the eve of the last crisis, the Fed owned $0.875 trillion in mortgages. By the end of 2021, it was three times higher—$2.6 trillion. This money is part of the $8.9 trillion in total Fed assets, up from $5.3 trillion right before the Coronadoom Panic.

Then there was the government takeover of student loans. First came the government-dictated “pause” in payments during the panic. Then the recent wiping away of a certain amount owed. These moves were billed as more solutions, in part to cover the soaring cost of college. But our authors recognize (emphasis theirs) “the bloated price of higher education is sustained by the student loan bubble.”

How, or is it even possible, to draw back the powers government assumed during the Coronadoom Panic? When the book was written in early 2022, the Fed “began discussing the possibility of shrinking its balance sheet.” But, as of the end of August 2022, there hasn’t been any shrinkage. It’s not only the US finance system, of course. It’s the same story in Switzerland, Canada, Japan, Europe, and wherever the panic was embraced.

If we keep looking to government for solutions, we might end up here:

[O]ne might even imagine the extreme case in which the central bank becomes the monopoly bank for the whole country, holding all consumer and business deposits, supplanting the private banking industry, and with its political agenda dominating the allocation of loans.

It no longer takes as much imagination as it did to envision this scenario.

*****

This article was published by Law & Liberty and is reproduced with permission.

A Brave New Financial World

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Estimated Reading Time: 7 minutes

The nation likely will drift into a situation in which its central bank will be expanding its regulatory and safety-net coverage, vainly trying to protect everything in the interest of protecting ‘banks.’ The tremendous power it will come to wield not only will be harmful to the structure of the financial system but also will make the Fed an even more formidable foe to those inside and outside the government who believe that it is too powerful already.
 James L. Pierce, “The Federal Reserve as a Political Power,” 1990

 

How can the Federal Reserve help you today? A few years ago, such a question would have been rather odd. The Federal Reserve was created a little over a century ago as an independent government agency with a rather small mandate: manage the money supply. It was an important, but limited, role. In normal times, the Fed existed to ensure the money supply grew at a reasonable rate. In times of crisis, the Fed would become the Lender of Last Resort, lending funds to solvent banks to get them through a crisis. But, times have changed. The Fed, no longer tied to the mast, is here to take your order.

This new world is magnificently described in Lev Menand’s The Fed Unbound: Central Banking in a Time of Crisis. With impeccable brevity and precision, Menand details how the Fed has abandoned its historical mission, appropriating to itself a new mandate and powers of dubious legality. None of this has been done in secret. Its actions have been front page news, Congress has aided and abetted the unbinding, and as the quotation at the outset notes, it was all predictable in 1990. 

Monetary Policy before 2020

“The American Monetary Settlement” is Menand’s term for the world in which we used to live. Private commercial banks provided deposit accounts (both checking and savings) which constituted the bulk of what we used for money. The Federal Reserve System provides currency (also a form of money) and supervises the commercial banking system. The Fed also provides reserve accounts for commercial banks, which are used to transfer funds from one bank to another. By changing the volume of reserves in banks’ accounts, the Fed is able to exercise indirect control over the amount of money in the economy. The system has a remarkable simplicity, easily explained in any first-year economics class.

There have long been cracks in the money creation system. Over time, other types of accounts developed which also functioned as money, but were easily ignored when discussing the money supply. These other accounts were not provided by domestic commercial banks and thus existed in what became known as the Shadow Banking system. Menand points to three types of accounts (dealer repo accounts, Eurodollar accounts, and money market funds) which are all highly liquid and reasonably stable, and thus provide something that functions as money but pays a higher interest rate than a traditional deposit account at a commercial bank. Because none of these types of accounts are at commercial banks, the Fed has no regulatory authority over them and there are no precise measures of their size.

After the financial crisis of 2008, Congress passed the Dodd-Frank bill, which did nothing to alter the state of affairs that precipitated the financial crisis.

The shadow banking system suddenly found itself in the sun in 2008. Once a small part of the financial infrastructure, the shadow banking accounts had grown to be about twice as large as the measured money supply. When an old-fashioned bank run hit the shadow banking industry, there was a grave danger of the entire system falling apart, which would have generated a collapse in the money supply equivalent to that which caused the Great Depression. The Bernanke Fed exercised an enormous array of powers designed to shore up the shadow banking system to prevent such a collapse. It was a moment of genuine monetary peril, and the resulting recession was much milder than it would have been had the Fed done nothing.

In the wake of previous financial crises, Congress inevitably passed a bill creating a new set of regulations to prevent the same thing from happening again. After the financial crisis of 2008, Congress passed the Dodd-Frank bill, which did nothing to alter the state of affairs that precipitated the financial crisis. 

The 2020 Financial Crisis

The same crisis hit again in March 2020. With the arrival of Covid and the government lockdowns, the shadow banking system once again found itself reeling. This time, the Powell Fed acted promptly, using the same bag of tricks which the Bernanke Fed had stumbled into discovering. It wasn’t enough, so the Fed’s range of actions expanded. The panic ended and the shadow banking system stayed intact. But, as Menand describes in detail, the American Monetary Settlement was destroyed.

The result has been nothing short of a transformation in the Fed’s role in our society. Not only have its unprecedented actions helped once again to avert economic collapse, but they have also changed what members of Congress and members of the public expect of the country’s central bankers. Today, the Fed is no longer just managing the money supply by administering the banking system. It is fighting persistent economic and financial crises by using its balance sheet like an emergency government credit bureau or national investment authority…

In 2008, the Fed invoked an obscure provision in its charter which allowed it to become the lender of last resort to financial firms other than the commercial banking system. In 2020, when that proved to be insufficient to stem the panic, the Fed tried something new: it started directly buying massive volumes of assets in order to prop up their prices. The Chair of the Fed announced that the Fed would not “run out of ammunition”—that they had unlimited resources to buy as many assets as needed. The rhetoric suggesting financial crises are the equivalent of war is revealing; in wartime, even democratically elected governments appropriate seemingly limitless powers over the economy.

That promise opened the floodgates. With unlimited access to the printing press, there seemed to be no limit to what the Fed could do. The financial panic of March 2020 subsided, but the economic problems were only beginning. Those problems extended far beyond the financial sector, so Congress passed the CARES Act, one provision of which was to allow the Fed to lend directly to businesses, both for-profit and non-profit. Suddenly the Fed found itself with the power to lend funds to whatever firm or industry it deemed worthy.

Beyond the nebulous legal problems, there is also the question of whether the society really wants this much power concentrated in an insulated, unelected group that operates with very limited congressional oversight.

The Fed did not stop there, however. Being the Lender of Last Resort by definition means the Fed is imposing an obligation to have the loans repaid at some point. That creates burdens on firms to whom the Fed has lent funds. To stimulate economic activity, and not incidentally to keep the interest rates low on government debt, the Fed began what commentators quickly dubbed QE Infinity. In effect, this was an open-ended commitment to keep buying as many financial assets as necessary to maintain low-interest rates.

What exactly now sets a limit on the Fed’s activity? With literally an unlimited amount of money at its disposal, and a mandate which has seemingly broadened to “do good things for the economy,” what should be its priorities? Now that the Fed has crossed the Rubicon by purchasing bonds from AT&T, Verizon, CVS, Comcast, GE, Apple, Microsoft, and so on, why not also your place of work or your favorite non-profit? Now that the Fed has lent to local municipalities, why not get free Fed money for your local school or community center? Is it any wonder that people are now seriously talking about what the Fed can do on the Climate Change agenda?

The world of the Unbound Fed is rife with peril. Menand barely scratches the surface of a world in which an unelected independent agency seemingly can create money to accomplish any goal it wants. We have entered a strange regulatory world in which it is no longer clear which rules the Fed must follow. Obviously, the Fed no longer is restrained to its traditional role of managing the money supply. What else is it now able to do, either legally or with Congress looking the other way?

Beyond the nebulous legal problems, there is also the question of whether the society really wants this much power concentrated in an insulated, unelected group that operates with very limited congressional oversight. The now implied promise always to backstop the shadow banking system operating outside of the normal regulatory framework is a recipe for disaster. Using the money supply to finance whatever initiatives Congress wants to accomplish has already resulted in unprecedented growth in the money supply and the inevitable inflationary consequences.

Favoritism is inevitable. In the old days, the Fed avoided favoritism by lending to any commercial bank with good collateral. The only asset it purchased when it wanted to create more bank reserves was US government debt. In 2008, the Fed had to decide which parts of the shadow banking system it wanted to aid in order to prevent a collapse of the money supply (Lehman Brothers: no; AIG: yes). After 2020, the Fed no longer has to restrict itself to financial firms or concerns about the money supply. It will inevitably play favorites.

What Next?

Having laid out the reasons for, and the problem with, the Fed Unbound, Menand naturally enough turns to solutions. Alas, this is where the book founders. We should not fault Menand too much, though; it is not at all clear that there is an easy solution.

He offers two routes forward. First, he asserts the need for “a healthier macroeconomic policy mix.” It is hard to argue with that. After all, the most important reason to have an independent central bank is to prevent the legislature from having access to the printing press to fund every spending idea which comes along. Menand himself illustrates the problem. This discussion is one of the places for Menand’s periodic odd and inexplicable intrusion of his own vaguely leftist political agenda into the book. If the author of a book warning against the dangers of an unbound Fed cannot resist introducing his own legislative agenda into the argument, why should we expect members of Congress to keep their own legislative ambitions separate from a seemingly easy way to finance them?

Secondly, Menand suggests reining in the new financial world. Looking back to the world before 2008, it seems like we could return to those halcyon days gone by “enforcing the regulatory perimeter.” If the problem is types of accounts that function as money but are created outside the traditional commercial banking system, then why not either eliminate the possibility of such accounts or bring them under Fed supervision? Theoretically, that is possible. But, given that the shadow banking system is twice as large as the currently supervised banking system, this is not a small disruption to the monetary system. There is simply no way to predict the economic impact of trying to rewrite the rules on what types of accounts can be offered by what types of financial firms.

The problem with reining in the financial world is complicated by technological developments which have made it easier to create new types of accounts, using new types of assets (e.g. cryptocurrency), which may or may not end up functioning like money in limited sets of markets. No matter where you set the regulatory perimeter, there will be enormous financial incentives to set up shop right on the other side of that border.

These sorts of questions compound the longer you think about this new world of money. Unfortunately, the government does not have a good record when it comes to thinking through the monetary implications of the shadow banking industry. Will they sort this out before the next crisis, as they failed to do in 2008 and 2020? It’s hard to be optimistic, but, if you are not yet troubled by this new world, get a copy of The Fed Unbound.

*****

This article was published by Law & Liberty and is reproduced with permission.

The Fed’s Tough Year

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Estimated Reading Time: 10 minutes

The powerful and prestigious Federal Reserve is having a tough year in 2022 in at least three ways:

  • It has failed with inflation forecasting and performance;
  • It has giant mark-to-market losses in its own investments and looming operating losses;
  • It is under political pressure to do things it should not be doing and that should not be done at all.

Forecasting Inflation

As everybody knows, the Fed’s overoptimistic inflation forecasts for the runaway inflation year of 2021 were deeply embarrassing. Then the Fed did it again for 2022, with another wide miss. In December 2021, it projected 2022 Personal Consumption Expenditures inflation at 2.6%, while the reality through June was 6.8%, with Consumer Price Index inflation much higher than that. It would be hard to give the Fed anything other than a failing grade in its supposed area of expertise.

The Fed’s interest rate forecast for 2022 was three federal funds target rate increases of 0.25% so that its target rate would reach 0.9% by the end of 2022. It forecast the rate at 2% by the end of 2024. Instead, by July 2022, it already reached 2.5%.

In short, the Federal Reserve cannot reliably forecast economic outcomes, what the results of its own actions will be, or even what its own actions will be. Of course, neither can anybody else.

It is essential to understand that we cannot expect any special economic or financial insight from the Federal Reserve. This is not because of any lack of intelligence or diligence, or not having enough computers or PhDs on the payroll, but of the fundamental and inevitable uncertainty of the economic and financial future. Like everybody else, the Fed has to make decisions in spite of this, so it will unavoidably make mistakes.

We should recall how Ben Bernanke, then Chairman of the Federal Reserve, accurately described his extended “QE” strategy in 2012 as “a shot in the proverbial dark.” That was an honest admission, although unfortunately, he admitted it only within the Fed, not to the public.

The Governor of the Reserve Bank of Australia (their central bank) described the bank’s recent inflation forecasting errors as “embarrassing.” Such a confession would also be becoming in the Federal Reserve, especially when the mistakes have been so obvious. The current fed funds rate of 2.5% may sound high today, if you have become used to short-term rates near zero and you have no financial memory. But it is historically low, and as many have pointed out, it is extremely low in real terms. Compared to CPI inflation of 8.5%, it is a real interest rate of negative 6%.

Savers will be glad to be able to have the available interest rates on their savings rise from 0.1% to over 2%, but they are still rapidly losing purchasing power and having their savings effectively expropriated by the government’s inflation.

Although in July and August 2022 (as I write), securities prices have rallied from their lows, the 2022 increases in interest rates have let substantial air out of the Everything Bubble in stocks, speculative stocks in particular, SPACs, bonds, houses, mortgages, and cryptocurrencies that the Fed and its fellow central banks so assiduously and so recklessly inflated.

A Mark-to-Market Insolvent Fed

Nowhere are shrunken asset prices more apparent than in the Fed’s own hyper-leveraged balance sheet, which runs at a ratio of assets to equity of more than 200. As of March 31, 2022, the Fed disclosed, deep in its financial statement footnotes, a net mark-to-market (MTM) loss of $330 billion on its investments. Since then, the interest rates on 5 and 10-year Treasury notes are up about an additional one-half percent. With an estimated duration of 5 years on the Fed’s $8 trillion of long-term fixed rate investments in Treasury and mortgage securities, this implies an additional loss of about $200 billion in round numbers, bringing the Fed’s total MTM loss to over $500 billion.

Compare this $500 billion loss to the Fed’s total capital of $41 billion. The loss is 12 times the Fed’s total capital, rendering the Fed technically insolvent on a mark-to-market basis. Does a MTM insolvency matter for a fiat currency-printing central bank? An interesting question—most economists argue such insolvency is not important, no matter how large. What do you think, candid Reader?

The Fed’s first defense of its huge MTM loss is that the loss is unrealized, so if it hangs on to the securities long enough it will eventually be paid at par. This would be a stronger argument in an unleveraged balance sheet, which did not have the Fed’s $5 trillion floating rate liabilities. With the Fed’s leverage, however, the unrealized losses suggest that it has operating losses to come if the higher short-term interest rates implied by current market prices come to pass.

The Fed’s second defense is that it has changed its accounting so that realized losses on securities or operating losses will not affect its reported retained earnings or capital. Instead, the resulting debits will be hidden in a dubious “deferred asset” account. Just change the accounting! (This is exactly what the insolvent savings and loans did in the 1980s, with terrible consequences.)

What fun it is to imagine what any senior Federal Reserve examiner would tell a bank holding company whose MTM losses were 12 times its capital. And what any such examiner would say if the bank proposed to hide realized losses in a “deferred asset” account instead of reducing its capital!

Here is a shorthand way to think about the dynamics of how Fed operating losses would arise from their balance sheet: The Fed has about $8 trillion in long-term, fixed-rate assets. It has about $3 trillion in non-interest-bearing liabilities and capital. Thus, it has a net position of $5 trillion of fixed rate assets funded by floating rate liabilities. (In other words, inside the Fed is the financial equivalent of a giant 1980s savings and loan.)

Given this position, it is easy to see that pro forma, for each 1% rise in short-term interest rates, the Fed’s annual earnings will be reduced by about $50 billion. What short-term interest rate would it take to wipe out the Fed’s profits? The answer is 2.7%. If their deposits and repo borrowings cost 2.7%, the Fed’s profits and its contribution to the U.S. Treasury will be zero. If they cost more than 2.7%, as is called for in the Fed’s own projections, the Fed starts making operating losses.

How big might these losses be? In the Fed staff’s own recent projections, in its most likely case, the projected operating losses add up to $60 billion. This is 150% of the Fed’s total capital. In the pessimistic case, losses total $180 billion, over 4 times its capital, and the Fed makes no payments to the Treasury until 2030.

In such cases, should the Fed’s shareholders, who are the commercial banks, be treated like normal shareholders and have their dividends cut? Or might, as is clearly provided in the Federal Reserve Act, the shareholders be assessed for a share of the losses? These outcomes would certainly be embarrassing for the Fed and would be resisted.

The central bank of Switzerland, the Swiss National Bank (SNB), did pass on its dividends in 2013, after suffering losses. The SNB Chairman gave a speech at the time, saying in effect, “Sorry! But that’s the way it is.” Under its chartering act, the SNB—completely unlike the Fed—must mark its investment portfolio to market in its official profit and loss statement. Accordingly, in 2022 so far, the SNB has reported a net loss of $31 billion for the first quarter and a net loss of $91 billion for the first six months of this year.

The Swiss are serious people, and also serious, it seems when it comes to central bank accounting and dividends.

In the U.S., the Federal Reserve Bank of Atlanta did pass its dividend once, in 1915. As we learn from the Bank’s own history, “Like many a struggling business, it suspended its dividend that year.” Could it happen again? If the losses are big and continuing, should it?

A third Fed defense is that its “mandate is neither to make profits nor to avoid losses.” On the contrary, the Fed is clearly structured to make seigniorage profits for the government from its currency monopoly. While not intended by the Federal Reserve Act to be a profit maximizer, it was also not intended to run large losses or to run with negative capital. Should we worry about the Fed’s financial issues, or should we say, “Pay no attention to the negative capital behind the curtain!”

The Fed is obviously unable to guarantee financial stability. No one can do that. Moreover, by trying to promote stability, it can cause instability.

What the Fed Can and Can’t Do Well

The Federal Reserve is also suffering from a push from the current administration and the Democratic majority in the House of Representatives to take on a politicized agenda, which it probably can’t do well and more importantly, should not do at all.

This would include having the Fed practice racial preferences, that is, racial discrimination, and as the Wall Street Journal editors wrote, “Such racial favoritism almost certainly violates the Constitution. So does the [House] bill’s requirement that public companies disclose the racial, gender identity and sexual orientation of directors and executives.” The bill would “politicize monetary policy and financial regulation.” A lot of bad ideas.

Moreover, the Federal Reserve already has more mandates than it can accomplish, and its mandates should be reduced, not increased.

As has been so vividly demonstrated in 2021 and 2022, the Fed cannot accurately forecast economic outcomes, and cannot know what the results of its own actions, or its “shots in the proverbial dark,” will be.

Meanwhile, it is painfully failing to provide its statutory mandate of stable prices. Note that the statute directs the goal of “stable prices,” not the much more waffly term the Fed has adopted, “price stability.” It has defined for itself that “price stability” means perpetual inflation at 2% per year.

The Fed cannot “manage the economy.” No one can.

And the Fed is obviously unable to guarantee financial stability. No one can do that, either. Moreover, by trying to promote stability, it can cause instability, an ironic Minskian result—Hyman Minsky was the insightful theorist of financial fragility who inspired the slogan, “stability creates instability.”

There are two things the Fed demonstrably does very well.

The first is financing the government. Financing the government of which it is a part is the real first mandate of all central banks, especially, but not only, during wars, going back to the foundation of the Bank of England in 1694. As the history of the Atlanta Fed puts it so clearly:

During the war [World War I], the Fed was introduced to a role that would become familiar…as the captive finance company of a U.S. Treasury with huge financing needs and a compelling desire for low rates.

This statement is remarkably candid: “the captive finance company of [the] U.S. Treasury.” True historically, true now, and why central banks are so valuable to governments.

The second thing the Fed does well is emergency funding in a crisis by creating new money as needed. This was its original principal purpose as expressed by the Federal Reserve Act of 1913: “to furnish an elastic currency,” as they called it then. This it can do with great success in financial crises, as shown most recently in 2020, and of course during wars, although not without subsequent costs.

However, the Fed is less good at turning off the emergency actions when the crisis is over. Its most egregious blunder in this respect in recent years was its continuing to stoke runaway house price inflation by buying hundreds of billions of dollars of mortgage securities, continuing up to the first quarter of 2022. This has severe inflationary consequences as the cost of shelter drives up the CPI and erodes the purchasing power of households. Moreover, it now appears the piper of house price inflation is exacting its payment, as higher mortgage rates are resulting in falling sales and by some accounts, the beginning of a housing recession.

Among the notions for expanding the Fed’s mandates, the worst of all is to turn the Fed into a government lending bank, which would allocate credit and make loans to constituencies favored by various politicians. As William McChesney Martin, the Fed Chairman 1951-1970, so rightly said when this perpetual bad idea was pushed by politicians in his day, it would “violate a fundamental principle of sound monetary policy, in that it would attempt to use the credit-creating powers of the central bank to subsidize programs benefitting special sectors of the economy.”

It is a natural and permanent temptation of politicians to want to do just that—to use the money printing power of the central bank to give money to their political supporters without the need for legislative approval or appropriation and to surreptitiously finance it by imposing an inflation tax without legislation.

One way to achieve this worst outcome would be to have the Fed issue a “central bank digital currency” (CBDC) that allows everybody to have a deposit account with the Fed, which might then become a deposit monopolist as well as a currency monopolist.

Should that happen, the Fed would by definition have to have assets to employ its vastly expanded deposit liabilities. What assets would those be? Well, loans and securities. The Fed would become a government lending bank.

The global experience with such government banks is that they naturally lend based on politics, which is exactly what the politicians want, with an inevitable bad ending.

On top of that, with a CBDC in our times of Big Data, the Fed could and probably in time would choose to know everybody’s personal financial business. This could and perhaps would be used to create an oppressive “social credit system” on the model of China which could control credit allocation, loans, and payments. Given the urge to power of any government and of its bureaucratic agencies, that outcome is certainly not beyond imagining, and is, in my view, likely.

The current push to expand the Fed’s mandates is consistent with Shull’s Paradox, which states that the more blunders the Fed makes, the more powers and prestige it gets. But we should be reducing the Fed’s powers and mandates, not increasing them. Specifically:

  • The Fed should not hold mortgage securities or mortgages of any kind. It should take its mortgage portfolio not just to a smaller size, but to zero. Zero was just where it was from 1914 to 2008 and where it should return.
  • The Fed should not engage in subsidizing political constituencies and the proposed politicized agenda should be scrapped.
  • Congress should definitively take away the Fed’s odd notion that the Fed can by itself, without Congressional approval, set a national inflation target and thereby commit the country and the world to perpetual inflation.
  • Congress should repeat its instruction to the Fed to pursue stable prices. As Paul Volcker wrote in his autobiography, “In the United States, we have had decades of good growth without inflation,” and “The real danger comes from encouraging or inadvertently tolerating rising inflation and its close cousin of extreme speculation and risk taking.”
  • The Fed should be required to have sound accounting for its own financial statements, with no hiding losses in the former savings and loan style allowed. This requires taking away from the Fed the power to set its own accounting standards, which nobody else has.
  • The Fed should be prohibited from buying TIPS (Treasury Inflation-Protected Securities), because this allows it to manipulate apparent market inflation expectations.
  • The funding of the Consumer Financial Protection Bureau expenses out of Fed profits should be terminated. This is an indefensible use of the Fed to take away the power of the purse from Congress and to subsidize a political constituency. It would be especially appropriate to end this payment if the Fed is making big losses.
  • Finally, and most important of all, we must understand the inherent limitations of what the Federal Reserve can know and do. There is no mystique. We must expect it to make mistakes, and sometimes blunders, just like everybody else.

Knowing this, perhaps the 2020s will give us the opportunity to reverse Shull’s Paradox.

This paper is based on the author’s remarks at the American Enterprise Institute conference, “Is It Time to Rethink the Federal Reserve?” July 26, 2022.

*****

This article was published in Law & Liberty and is reproduced with permission.

The Renewed Politicization of the Federal Reserve

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Estimated Reading Time: 4 minutes

Economic research shows that monetary policy works best when conducted by an independent central bank. After Fed chairs in the 1960s and ‘70s caved to pressure from American Presidents, those who followed sought, at least to some degree, to reestablish the Fed’s independence. Until now, that is.

Since 2019, the Fed has politicized its activities in virtually every way: through its monetary policy goals, the use of its enhanced balance sheet, its regulatory actions, and its emergency lending activities. Each of these changes has pushed the Fed further from being an effective and independent central bank toward becoming a purely political institution, which prevents it from choosing the best policies for Americans and the US economy.

Monetary Policy: “Inclusive” Employment and (Flexible) Average Inflation Targeting

Fed officials, including current Chair Jerome Powell, have acknowledged that monetary policy is a broad tool that cannot be used to address the problems of racial and income inequality. Despite this admission, however, the Fed has injected the issue of inequality into its monetary policy goals.

In August of 2020, the Fed rewrote its statement of goals and strategy to emphasize employment ahead of inflation. The new language described the maximum employment goal as “a broad-based and inclusive goal that is not directly measurable.” Chair Powell cited racial differences in unemployment rates as a motivation for the change. This shifted the Fed’s goal from focusing on the best outcome for most Americans to a purely discretionary target, which the Fed admits is impossible to measure.

At the same time, the new objectives stated that the Fed would target a rate of two percent inflation averaged over time, giving Fed officials greater ability to deviate from the prescribed rate of two percent annual inflation. Moreover, Fed officials have since revealed that they only intend to seek an average of two percent when it has previously been below target. When inflation is above target, in contrast, the Fed will allow it to remain so and will not bring it down enough to return to the previous price-level trend.

Taken together, these two changes relax the traditional constraints on the Fed’s ability to engage in overly-expansionary monetary policy. When warned that the policy is too loose, they can point to their expanded employment goal to justify the policy. Then, when inflation rises above two percent, they can claim that it is temporary and will not affect the average rate of inflation in the future.

The irony is that such an approach would likely produce exactly the opposite of what is intended. To the extent that emphasizing maximum employment (in the broader sense) and ignoring temporary periods of above-average inflation results in overly-expansionary monetary policy, it risks recessionary corrections and even lower employment than would have occurred had the Fed stuck with its previous policy.

In early 2021, for example, Chairman Powell testified that the Fed planned to keep its interest rate targets near zero until the economy reached maximum employment, a policy it maintained throughout 2021 despite record inflation. Powell now says the US labor market is “unsustainably hot,” but the Fed has taken only minimal action to calm the labor market or bring down inflation. Many commentators are already expressing concerns about a looming recession.

Balance Sheet Activities: Fiscal Accommodation

Through the use of large-scale asset purchases (LSAPs), also known as quantitative easing (QE), the Fed has massively expanded its balance sheet from less than $1 trillion in 2008 to almost $9 trillion today. While the federal government increased fiscal spending by $5 trillion in response to the Coronavirus pandemic, the Fed bought up more than $3.4 trillion in Treasury securities since 2019, effectively monetizing a large portion of the fiscal deficit.

While some economists applauded the Fed’s fiscal accommodation, debt monetization is not a prudent action of a responsible central bank. Those that engage in such activities encourage profligate spending by their fiscal authorities, which often ends up in fiscal default. Such massive purchases of Treasury securities were enabled by the Fed’s enlarged balance sheet and would not have been possible in the pre-2008 system.

Emergency lending: Everyone Gets a bailout!

One traditional function of central banks is that they act as emergency lenders in times of financial crises. Although the Fed’s 2008 emergency lending deviated from the rules of the classical lender of last resort, former Fed Chairs Bernanke and Yellen respected the limits of the Fed’s authority as understood by economists and stated in the Federal Reserve Act.

Not so for Jerome Powell. Despite the fact that 2019 was not a case of “unusual and exigent” circumstances in terms of bank failures or shortages of financial liquidity, the Fed initiated a variety of emergency lending facilities beyond those of the 2008 crisis. The Fed lent to non-financial companies and state and local governments, which former Fed chairs said it should never do.

These actions disturb the efficient allocation of capital in the financial system and further heighten the Fed’s political profile.

Regulation: Climate and Industrial Policies

Bank regulators have increasingly used their regulatory powers to discourage banks from supporting politically unpopular industries, such as oil and gas, firearms, and medical marijuana. These punitive measures often take the form of discretionary enforcement actions, which lack the transparency and immutability of rules passed through the regulatory process.

Fed regulators have now turned their sights to climate change and the supposed threat it poses to US banks. The Fed subjects banks to “climate stress tests” and has joined international central banks’ Network for Greening the Financial System (NGFS), whose stated goal is to “support the transition toward a sustainable economy.” While these changes are ostensibly made in the name of limiting banks’ risk exposure, their result in practice will be to harm the US economy by preventing banks from lending for specific purposes such as the production of energy and fossil fuels.

The Fed’s Politics Threatens Its Independence

Fed officials have gone beyond policy discretion into overt political activism. President of the Minneapolis Federal Reserve Bank Neel Kashkari has been reprimanded by Senator Pat Toomey for his recent political actions. In 2020, former New York Fed President Bill Dudley argued that “Fed officials should consider how their decisions will affect the political outcome” by potentially withholding monetary accommodation in order to prevent the re-election of President Donald Trump. Such actions reveal these officials to be political opportunists rather than independent central bankers.

Independent central banks tend to deliver better monetary policy. But independence can only be maintained by focusing on the narrow goals assigned by Congress. By straying from its mandate, Fed officials have chosen to base their decisions on politics rather than on sound economics.

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This article was published by AIER, American Institute for Economic Research, and is reproduced with permission.