“The Fed – Where is it Headed?"

Sydney M. Williams

Thought of the Day

“The Fed – Where is it Headed?"

September 22, 2011

Most central banks around the world have a single mandate – stable prices. Not so the Federal Reserve System of the U.S. The Federal Reserve was established in 1913 in response to the Panic of 1907, which, like its counterpart 101 years later, brought the financial system to its knees. Its duties include the conduct of monetary policy, the supervision and regulation of the banking industry, the maintenance of stability in the financial system and the providing of services to depository institutions. With the enactment of the Federal Reserve Reform Act of 1977, endowing the Federal Reserve with the power to “promote effectively the goals of maximum employment, stable prices and moderate long term interest rates,” the potential for conflicting goals was established.

Like most institutions, the role of the Fed has changed over the years and, unlike other government organizations, it has generally been given high marks – not withstanding the disastrous consequences of Chairman Greenspan’s easy money policy in the 00s, and despite Governor Perry’s incredible characterization of the current Chairman as “almost treasonous.”

The System is unique in that its decisions do not have to be ratified by the President or anyone else in the executive or legislative branch of government. Its authority, however, is derived from Congress and is subject to Congressional oversight. Members of its Board, including the Chairman, are chosen by the President and confirmed by the Senate. The twelve regional presidents are selected by their regional bank boards – a condition that Representative Barney Frank would like to change. Four of those presidents, on a rotating basis, sit on the Federal Open Market Committee (FOMC) alongside the Chairman, the seven governors and the President of the New York Fed. Mr. Frank would also like to strip the regional banks from any voting membership. As the Wall Street Journal noted yesterday, the Congressman’s attempt reflects his preference for easy versus sound money. I agree with the Journal, in their conclusion that the regional presidents should have more, not less, influence.

Attempts by politicians to interfere in the dealings of the Fed should be resisted, and that includes not only the ridiculous meddling by Barney Frank, but also interferences like the letter sent by four Republicans Congressional leaders Monday urging the Fed to do nothing at yesterday’s meeting. While I am a fan of sound money and worry about the inflationary consequences of the Fed’s printing money at the rate it is, I am even more a fan of the Fed maintaining its independence.

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The Fed’s FOMC’s statement issued yesterday afternoon contained little of surprise; though markets focused on the insertion of “significant” when they spoke of downside risks to the economic outlook. The Fed plans to reinvest $400 billion in longer dated securities – Treasuries, Agencies and Mortgage-backed securities – as existing, short-dated positions mature. The $400 billion represents 15.4% of their $2.6 trillion balance sheet. The program should, the statement says, “put downward pressure on longer-term interest rates and help make broader markets more accommodative.” “Economic growth remains slow…and the unemployment rate remains elevated.” “The housing sector remains depressed.” The last three statements are uncomfortably obvious to anyone. The first raises the question: How low do we want longer-term rates to go? They are already at multi-decade lows. For example, the yield on the Thirty-year sold at 2.9% this morning, only 15 basis points above the 2.75% yield on the 391 dividend paying stocks in the S&P 500. (The problem is confidence, not rates.) As in July, three Fed regional presidents – Richard Fisher, Narayana Kocherlakota and Charles Plosser – voted against the action, as they “did not support additional policy accommodation at this time.”

It is interesting, however to look back over the past thirty-two months and, as President Obama admonished his listeners on Monday, to look at the math, or at least the numbers. In January 2009, a week after Mr. Obama was sworn in as President, the Fed lowered the Fed Funds rate to a range of 0.0% to 0.25%. This was despite the fact that the credit markets, as measured by the TED spread, had shown remarkable improvement by December 2008, from its high in October. Fed Funds have continued at this low level. During the intervening thirty-two months, the Fed has expanded its balance sheet by about $300 billion to $2.6 trillion.

In the months since, some of the news has been good. Gold has risen 92% and stocks are up 42%. Treasuries have rallied with the yield on the Ten-year declining 30%; existing single family home prices are up 6.5%; the NBER declared the recession over as of May 2009, and thirty-year conforming mortgage rates have declined 21%, from 5.05% to 4.0% last month. Of course, for those who do not own gold or stocks and/or those who are savers, not borrowers, some of the “good” news has been bad, as the yields on T-Bills, CDs and money market funds are di minimis.

Some of the news has been bad. The Dollar has declined 10%, inflation has eroded purchasing power by 5%, unemployment has risen from 7.6% to 9.1%, and whatever economic recovery we had in 2009-2010 slowed noticeably in the first half of this year. GDP, which averaged 4.2 percent in the second half of 2009, declined to 2.8 percent in 2010 and then fell to 0.9 percent in the first half of 2011.The results – the math – suggest that the Fed’s actions have been the equivalent of pushing on a string, and one suspects the Administration’s focus on an $800 billion government spending bill and a massive healthcare overhaul would have been better spent on easing, not tightening, regulations, and implementing tax and entitlement reform.

In the late afternoon yesterday, the market voted on the Fed’s decision, with the Dow Jones Industrial Averages declining 2.6% in the one hour and forty minutes following their announcement. Mr. Bernanke and most commentators have referred to the Fed’s decision as the “twist,” named, they claim, after Chubby Checker’s song of that name, a dance I vaguely remember doing fifty years ago. I would suggest that it might more appropriately be named after Charles Dickens’ character in his eponymous novel, Oliver Twist. Oliver was an orphan, treated cruelly in his early years, and so was perhaps named “Twist” by Dickens for those troubled souls who did so much to damage Oliver’s will.

As to where the Fed is now headed, I don’t know; I worry more about the lack of a coherent fiscal strategy.