Keeping Its Distance: Can the Fed Be Effective, Innovative — and Independent?

The U.S. Federal Reserve Bank played a central role in mounting a response to the financial crisis of 2008. The Fed, battling unprecedented disasters — a meltdown in the financial system, the collapse of the housing market and a severe recession — responded with what experts describe as creative, even heroic, measures. But in the wake of that crisis, the Fed faces new challenges, including an increasingly critical Congress, at a time when the central bank’s responsibilities have expanded in significant ways. That will require the Fed to more effectively monitor a rapidly changing financial landscape, while also maintaining its independence from politicians in Washington.

Observers seem to agree that the Federal Reserve mishandled the period leading up to the crisis of 2008 but then responded forcefully and innovatively when the meltdown erupted. “The Federal Reserve was asleep at the switch in terms of anticipating the problems,” says Jack Guttentag, professor emeritus of international banking at Wharton, who now runs a website for mortgage borrowers. “There was no recognition of the possibility of a housing bubble that could have such far-reaching repercussions. There was a mindset that [the housing market] was more or less immune to that.”

Once the bubble burst, the Fed’s actions were swift and aggressive. Wharton finance professor Richard Marston notes that in the fall of 2008, the Fed, led by Ben Bernanke (who had only been in his post since 2006), stepped in and, by purchasing assets, provided a massive infusion of capital to the nation’s banks. Cash on hand at commercial banks tripled that fall, according to Marston, from less than $400 billion to more than $1 trillion, a surge in liquidity that was critical for heading off disaster. “During the [1930s] depression, as banks failed, the Fed allowed the money supply to decline rapidly,” a decision that contributed significantly to the economic implosion. Bernanke, a student of the Great Depression, clearly learned that lesson, Marston adds.

The Fed under Bernanke also used new tools in ways that many say lessened the damage. According to Marston, when the commercial paper market — a key financing option for major U.S. corporations — dried up in the fall of 2008, the Federal Reserve stepped in to support it by buying commercial paper. “Bernanke and his team were very creative in the weapons they used to save the system,” says Marston. “We are talking about heroic interventions.” Wharton’s Guttentag echoes that view. “The potential for catastrophe was high, but we sailed through it fairly well. It could have been worse than the 1930s.”

Some of the Federal Reserve’s later moves, however, have led to more controversy. The Fed has embarked on two rounds of what is called quantitative easing, the first in March of 2009 and the second in the fall of 2010. In quantitative easing, the Fed prints money and uses those funds to buy bonds and mortgage-related securities — purchases aimed at lowering borrowing costs and stimulating the economy. The Fed shifted to this strategy after it had cut the funds rate to near zero but found that longer-term rates remained relatively high and unemployment continued to climb. “When the Fed funds rate was brought down in 2007 and 2008, that didn’t have as much of an effect on long-term rates,” says Wharton finance professor Krista Schwarz. The result: “Borrowing costs were rising, and the availability of credit was still constrained.”

While there is less criticism of the first round of quantitative easing, the second round, known as QE2, has been attacked in many circles. “It expands the money supply by providing more cash to banks,” Marston notes. “But banks have far more cash than they need, and it has not had much of an effect on interest rates. The one effect it has had is boosting the stock market — the stock market loves quantitative easing.” That may help the economy by making Americans feel wealthier and more likely to spend, Marston states. But the real danger is that it sets the stage for an inflationary spike down the road. “The Fed will need to drain all this cash from the system.”

Kenneth Thomas, a Wharton lecturer in finance, contends that the Fed should have expanded the first round of quantitative easing, a move that would have made a second round unnecessary. “Bernanke underestimated how bad things were,” Thomas notes. “If he had continued QE1, there would have been enough stimulus to get us through the European sovereign debt crisis.” He suggests that front loading the effort in that way would have allowed the Fed to plan for the eventual withdraw of all this excess liquidity earlier.

How Close Is Too Close?

Regardless of the wisdom of the quantitative easing strategy, most Fed watchers say the crisis of the last few years has brought the Federal Reserve closer to the White House, a potentially problematic shift. According to Thomas, this move began under Alan Greenspan’s tenure at the helm of the Fed. “Between 1996 and 2000, Greenspan went to the White House about once a month. But after 2000 that increased, at one point hitting 70 visits a year. He was stepping beyond the boundaries of what we consider normal and threatening the political independence of the Fed.”

Allan Meltzer, professor at Carnegie Mellon’s Tepper School of Business and author of A History of the Federal Reserve, Volumes 1 and 2, is also concerned by the Fed’s close ties to the Treasury Department and the White House. “Monetary policy is about preventing inflation and acting in a way that is independent of governments,” Meltzer says. “Governments have a long history of wanting to use central banks to finance their activities — especially their debt. It is too easy for the government to run huge deficits when it knows the Fed will finance them. In other countries we have had a movement toward independent central banks, but the U.S. has moved in the opposite direction.”

In fact, the Federal Reserve faces a challenge in managing an increasingly complex relationship with members of Congress. Wharton’s Marston says it is clear that in the aftermath of the financial crisis, “the attitude toward the Fed has deteriorated” on Capitol Hill. Case in point: the hold up on the nomination of Nobel prize-winner Peter Diamond, who was tapped by President Obama to join the seven-person Board of Governors back in April 2010. Gregory Nini, Wharton professor of insurance and risk management, suggests that “there is a push to increase oversight from Congress.” That comes with some risk, Nini warns: “It is dangerous to politicize monetary policy because it can result in [measures] that sacrifice long-term stability for near-term politically beneficial gains.”

Thomas also believes that Bernanke has gone too far in building his relationship with members of Congress. In examining Bernanke’s publicly available calendar, Thomas notes that the chairman contacted 24 members of the Senate and 18 out of 23 members of the Senate Banking Committee during the period when he was being re-nominated for his position by President Obama in 2009. “I have never seen in such a short period of time such a full court press on political authorities by the head of the Fed.”

But if that contact brings criticism, it also reflects a move by the Fed toward greater transparency, something most Fed watchers agree is a positive development. According to Schwarz, the increased openness by the Fed has been a gradual development. “The statements from the FOMC [Federal Open Market Committee] meetings used to be short and terse, only about five sentences,” Schwarz points out. “Now they are several paragraphs long.” And the Fed has just announced that Bernanke will soon begin holding quarterly press conferences — a break with the typically closed-mouth style of previous chairmen.

There is, of course, a price to this enhanced openness. Some members of the Board of Governors and heads of the regional Federal Reserve Banks have been outspoken recently in their criticism of QE2. And after press reports revealed the internal deliberations by the FOMC in the fall of 2010, the committee began a review of its communications policies. “Debate is healthy,” Schwarz notes. “But that should largely be behind closed doors. It is beneficial to have externally perceived consensus.” In fact, open disagreement can undercut the Fed’s effectiveness. Indeed, some reports in the press argue that the impact of QE2 on interest rates was somewhat diminished by criticism of the program on Capitol Hill and elsewhere — comments that left the impression that the Fed would be unable to undertake a similar program in the near future if it was needed.

‘Do You Want Street Smarts or Book Smarts?’

These pressures on the Fed come as the makeup of the board of governors is changing. There are two positions on the seven person panel to fill — Peter Diamond’s nomination is in limbo, and Kevin Warsh, a Morgan Stanley veteran, is stepping down at the end of March. And while Diamond’s economics expertise is not in doubt, some outsiders argue that the Fed should be adding board members with more real world experience. “Do you want street smarts or book smarts?” Thomas asks. “You might be better off getting someone who understands the markets, who has spent some time on Wall Street, rather than someone who is an academic expert.”

Regardless of who fills those slots, the Fed’s role will continue to evolve. Under the Dodd-Frank Wall Street Reform and Consumer Protection Act, the Federal Reserve serves on the council that is aimed at identifying financial firms that pose a systemic risk, a new group whose mission is to head off future disasters. “In the past, [the Fed] had the view it shouldn’t try to play a proactive role in managing bubbles,” says Schwarz. “It is going to be more attuned to that going forward.” But while Schwarz thinks the Fed’s analytics team is well suited to the task, others are not so sure. “The Fed is a hierarchical organization and is fairly homogenous in how people think,” notes Franklin Allen, a Wharton finance professor. “That tends to make them fairly effective at crisis management, but probably makes them less effective at spotting the next crisis.”

The Fed’s role is also questioned in the consumer protection area. Allen notes that being a consumer watchdog “isn’t the Fed’s forte. And the Fed, particularly the regional banks, are much closer to the banking industry than would be ideal” for such a task.

Indeed, Congress selected the Fed to administer the Truth in Lending Act, “but that area has always been a backwater, a low priority at the Fed,” according to Guttentag. The result “is that the home loan market is still a minefield for borrowers. None of the efforts to protect borrowers have been very effective, and some of them have imposed heavy costs on the lender community.” Guttentag says this problem is continuing; new rules that the Fed is drafting on loan originator compensation reflect the agency’s weakness in this area. “I’ve read the rules with care, and some of the regulations have been written by people who don’t understand how this market works,” Guttentag contends. His bottom line: “The Fed should not be in this [consumer protection] business anymore.”

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