Rein In the Fed

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Would you borrow from your children to solve personal financial problems if you had no realistic way ever to repay them? If you knew it would leave them financially weakened and less able to live as well as you do now? We as a society are doing exactly that to our children as we allow the Federal Reserve and politicians of both parties to borrow from tomorrow to bail us out of past overindebtedness and to live more comfortably today.

Few see this as a moral issue. Without question, it is! Americans are happy to accept political and monetary largesse with scarcely a thought about the negative impact it will inevitably have on subsequent generations. Centuries of history argue convincingly that debt levels, even well below ours today, have almost invariably been punished by extended periods of sluggish economic growth, often accompanied by significant securities market losses. Those consequences will be felt most egregiously in coming decades.

Current legislators could take a major positive step by reining in the Federal Reserve Board. Through its first 95 years, the Fed acquired a balance sheet of a bit more than $800 billion. To bail the U.S. out of the 2007-09 Financial Crisis, the Fed abandoned all financial discipline and exploded its balance sheet to about $4.5 trillion through a series of money printing episodes. In its more recent attempts at “normalization”, the Fed has raised interest rates from the zero bound and gradually reduced the balance sheet by nearly $1 trillion. Investors, however, have rebelled against the withdrawal of monetary ease with sharp stock market selloffs. And the Fed has apparently conceded defeat, trading “patience” for preemptory easing. That concession makes Wall Street happy, and makes it convincingly clear that the Fed has indeed adopted a third mandate in addition to its Congress-dictated duo of maintaining a stable currency and maximizing employment. Inflation of 2% per year now masquerades as stability. And maximizing employment provides cover for virtually any Fed action to manage the economy. It makes no sense to invest any small group of primarily academics and regulators with the power to exercise massive influence on the domestic and, in turn, world economy. Rarely, if ever, does the Fed have even a single member who has ever successfully run a major corporation, much less has the credentials to guide the world’s largest economy. The Fed’s assumed third mandate leads them to make decisions far beyond their areas of experience and competence.

Allowing the Fed to wield the power it now has is also creating massive stock market distortions. So much market reaction flows from Fed proclamations that analysts spend an inordinate amount of time attempting to interpret the slightest variations in language or attitude of Fed voting members. For many strategists this deciphering has become even more important than the analysis of underlying fundamental conditions. That dynamic becomes blatantly obvious when we see markets surge on an announcement of disappointing economic news, as the prospect for more stimulus increases.

The single most effective antidote to the recent circus of political attacks on the Fed, a 180 degree Fed policy turn and investment strategists’ guessing game about upcoming Fed easing would be to establish a transparent rule-based system to determine monetary policy. Such a system would almost certainly be preferable to the frequently flawed Chair-led decisions heavily influenced by personal perceptions and biases. The arguments against relying on a rule-based system typically involve pointing out how such a system would likely have led to an arguably unacceptable monetary position in one or more instances– as if the existing system itself has not placed the country in an extremely dangerous position. If a rule-based system appears imperfect, improve the rules. Clearly, each voting member of the Fed relies on his or her own set of rules in making monetary decisions. Those rules are not, however, publicly known, so we are left to speculate on how voters, especially the Chair, will make their decisions. The securities markets would be far better served if analysts knew the rules on which monetary decisions would be based. Strategists could then abandon the psychological analysis of voting members and their probable decision-making patterns and return to an analysis of how the data align.

Notwithstanding the best of intentions, the Fed in recent years has bet America’s future on a flawed (now failed) experimental monetary policy. Until we speak up loudly, we remain at risk of continued experiments further decimating the future economic prospects of our nation and coming generations.

Congress needs to step up now to rein in Fed power.