Earlier this week, the Wall Street Journal cited various analysts who posited that the Fed will retain its “vastly-expanded” role in the U.S. economy for the foreseeable future. I don’t doubt that this is what some at the Fed would like and what many in the market want. And – like or want it or not – relying on the Fed’s portfolio, excess-reserve, and reverse-repo programs could well be necessary if only because markets have grown so dependent on the central bank’s ready supply of financial opioids. As with any addiction, kicking the central-bank habit will be hard. But, the Fed’s prescription for happy pills comes at the grave cost of market dysfunction. The more we rely on the Fed, the less markets set prices for long-term productivity and efficiency and the more embedded grow incentives for heightened economic inequality.
Think through what a central bank that’s totally central to U.S. economic well-being really means. If the Fed runs the economy, then the market doesn’t.
That’s deeply worrisome not because the Fed wishes any of us ill, but because – wise though the Fed is – it’s not omniscient. The Fed rightly espouses market discipline as a necessary pillar of micro-prudential policy when it comes to banks. It should take this point to heart when it comes to itself, recognizing that market discipline spots problems before any governmental agency can because it has money on the line. Sometimes markets double down on risky bets – think 2008, of course. That’s why we have monetary and regulatory policy. But monetary and regulatory policy unchecked by market discipline is just as risky as markets uninhibited by wiser, more objective hands
The Fed has already taken on an awesome role far outside its normal ambit of fiddling with the Fed Funds rate. In the course of recent monetary-policy actions, the Federal Reserve has become the world’s largest bank, the biggest big-bank counterparty, the largest player in the repo market, and the world’s largest investor in Treasury and agency obligations. Less obviously, the bond and equity markets now live or die by every signal, no matter how faint, from the Fed. One wrong move in 2013 wrought the taper tantrum, so the Fed’s been very careful of late. Still, markets have only grown more dependent on the Fed since 2013, reacting not to actual economic developments but rather to what best-guess forecasts or algorithmic models think the Fed will do about them.
The Fed of course is now talking about retrenching its portfolio, adding yet another Fed-determined policy to all of those on which markets fixate at cost to their ability to anticipate real risk. And, even with a bit of rollback talk in the air, many at the Fed contemplate other significant central-bank preoccupations – dropping “helicopter money” around to substitute for failed fiscal policy and eradicating cash to make monetary policy simpler to execute close to the zero lower bound. The Fed is also furiously defending its other big jobs: supplier of emergency liquidity, master of the payment system, and arbiter of the U.S. financial structure and the future of big banks.
Is the Fed doing all this because it’s power mad? Of course not. The Fed is formidably insulated in its marble fortress from views other than its own, but it genuinely and earnestly tries to do right. It would say with some justice that it has taken on all of its huge responsibilities because no one else can undertake them with such positive impact on macroeconomic prosperity and financial stability.
This line of reasoning is particularly common when it comes to the huge financial-market role the Fed now plays as a result of its post-crisis approach to making monetary policy. As statements from many members of the Board and Reserve Bank presidents have said, the U.S. financial system has changed so much since 2008 that old-style policies simply won’t cut it anymore. The Fed has to be as omnipresent across the market as it is because markets won’t work if it isn’t – or so this thinking goes.
Is this really true – that is, must we live our economic lives hooked on the Fed? I don’t think so and that’s because I believe the new world the Fed contemplates is partly of its own making. How much change in the structure of the U.S. financial market comes from underlying transformation of financial intermediation due to technology or other externalities and how much lies at the hands of the Fed’s combined monetary and regulatory policies? A growing body of academic and even governmental research from outside the U.S. shows troubling unintended impact from recent Fed action, with FedFin research last year analyzing all this work and drawing our own conclusions based on it. The Fed’s read all this work and some inside the fortress are even persuaded by aspects of it.
But, like parents afraid to let the teenagers out for a drive without one of them in the passenger seat, the Fed’s afraid to take its enormous hand off the market’s steering wheel. There’s only so long a parent can guess what a child will do and manage the child’s doings to its liking. Stepping back carefully and letting the kids grow up is the best parenting policy. It also has a lot to commend itself to central banking.