Fed needs to become less important
The Federal Reserve certainly doesn’t suffer from a lack of outside advice. And lately, the advice is tilted toward a pause in increasing interest rates.
Saying that President Donald Trump is offering the Fed advice would be sugarcoating it. He is loudly protesting the interest-rate hikes that have already been adopted. And, as is his wont, he’s making it personal, essentially claiming that he was conned into appointing Jerome Powell as Fed chairman. Powell, the president complains, isn’t the lowinterest-rate guy Trump understood him to be.
But Trump is hardly alone in the campaign for a pause in interest-rate increases. Even the Wall Street Journal, ordinarily a supporter of a strong dollar, has editorialized in favor of a pause, citing a slowdown in foreign economies and tariff uncertainty here at home.
In a market economy, however, uncertainty is a permanent condition. If it’s not tariffs, it will be something else. Market economies are constantly in a state of turbulence, reacting to price signals, innovations and shifting preferences.
Unfortunately, the Fed has become a significant source of instability and uncertainty itself. That’s not what is desired from a central bank in a market economy. The Fed needs to make itself less important. It is a long way from achieving that. And the journey is likely to be rocky.
The Fed overreacted to the disruption of financial markets in 2008, straying far from its traditional role of ensuring liquidity in an emergency. Instead, the Fed undertook the role of healing the economy through a massive and unprecedented monetary intervention.
The Fed funds rate was dropped to zero and left there for nearly a decade. The Fed’s balance sheet ballooned from about $1 trillion to $4.5 trillion, in an attempt to stimulate the economy through monetary expansion.
Some of the Fed’s efforts to provide liquidity eased the emergency. But this attempt to heal the economy through a massive monetary intervention produced very little. The recovery was sluggish. The Fed consistently overestimated what the next tranche of monetary intervention would produce.
However, the massive intervention did create economic distortions that linger today. Artificially low interest rates have artificially increased the price of assets, including stocks.
The Fed owns $2.3 trillion of debt from the federal government, acting as an enabler for unsustainable deficit spending.
The Fed owns $1.7 trillion in mortgage-backed securities, artificially increasing home values and reducing returns to fixed-income investors.
Everyone knows that artificially low interest rates have artificially increased stock prices, but no one knows by how much. That’s why the markets gyrate with each hint or nod about what the Fed might do next.
There is also a moral dimension to this. The Fed consciously screwed small savers and fixed-income investors for nearly a decade. It is morally reprehensible for a central bank to induce people into riskier investments through artificially suppressing interest rates.
The Fed is in no hurry to unwind this massive, and largely unproductive, monetary intervention. The Fed funds rate remains well below historical averages. With respect to the balance sheet, the Fed is merely not fully reinvesting all of returned principal.
This leisurely pace means that the economic distortions and mistreatment of small savers and fixed-income investors will persist as well. And that’s not economically healthy.
Economic health is when the value of stocks is determined by the evaluation of investors about likely future performance, not by reading the tea leaves of speeches by members of the Fed’s Open Market Committee. And where the relative rewards of equities and bonds are determined by supply and demand, not by the decision of a handful of central bankers to go on a buying spree.
The main value of a central bank is to preserve the value of money over time, not to fine-tune the economy from quarter to quarter.
Federal law gives the Fed the dual objectives of full employment and price stability. Paradoxically, the Fed would do more to achieve them in the long run if it weren’t so hyperactive in attempting to manipulate them in the short run.