EDITOR NOTES: There’s always been a necessarily tense balance between the Federal Reserve and Congress--one that has kept a clear distinction and separation between monetary policy (providing liquidity) and fiscal policy (allocating capital). Under Fed Chief Powell, the balance has been disrupted in favor of Congress. This sets a very dangerous precedent. Now, Congress realizes it can use the Fed to do its bidding on a fiscal level. Although checks and balances have always been central to the integrity of American democracy, it’s now broken in the realm of monetary and fiscal policy. Can we say that government and the Fed hold more power now over the American people and their financial well-being than ever before?
The Federal Reserve’s mandate has greatly expanded. The US central bank used to be in charge of monetary policy. Now, thanks in part to short-sightedness by Congress, the Fed is doing fiscal policy, too. This mandate creep will cause economic and political problems for years to come.
Unfortunately, we can’t rely on the Fed to check itself. The Fed’s Board of Governors recently released its biannual report to Congress. The report details the Fed’s extraordinary policies in the wake of COVID-19, but overlooks several ominous developments, namely, the vanishing boundary between monetary and fiscal policy, and the politicization of central banking.
Central bankers and elected officials often have an uncomfortable relationship. Congressmen, senators, and presidents have often wanted the central bank to do more than is prudent. Thankfully, the Fed’s leaders have often stood up to politicians, while still complying with the letter of the law. When Ben Bernanke was Fed chair, he rejected calls for the Fed to help with the General Motors bailout. When Janet Yellen was Fed chair, she staunchly opposed the Fed rescuing Puerto Rico. Unfortunately Jerome Powell, the current Fed chair, seems unwilling to follow in his predecessors’ footsteps.
When Congress expanded the Fed’s mandate as part of the CARES Act, Powell should have complied while clarifying — loudly and publicly — what the Fed’s job is and what it isn’t. Instead, Powell acquiesced to a vast reorientation of the Fed’s mission that will ultimately make it less accountable and less effective.
Let’s review how the Fed has responded to COVID-19: Currently, the plan is to spend $2.3 trillion to stimulate the economy. Some of the Fed’s actions, like lowering interest rates and slashing bank reserve requirements, are orthodox monetary policy. Some is taken from the 2007-8 playbook, including another round of quantitative easing. This is more troubling, but at least has some precedent. Most concerning are the Fed’s truly novel policies: direct loans to non-financial businesses, as well as state and local governments. This is preferential credit allocation, which is beyond the Fed’s competency. Furthermore, many of these programs are backstopped by the Treasury. This means that, if the Fed’s loans don’t perform, taxpayers must pick up the tab.
Section 13(3) of the Federal Reserve Act authorizes emergency loans to non-bank organizations, if making those loans can stave off a financial panic. But unlike in 2007-8, the risks of a full-blown financial crisis in March or April were low. Don’t take my word for it: In a recent 60 Minutes interview, Powell frankly admits that the economic turmoil caused by COVID-19 was in real goods and services markets, not financial markets. This is confirmed in the Fed’s report to Congress. The report highlights a host of liquidity concerns. But these are not signs of a financial panic. Indicators of financial distress, such as the Treasury-Eurodollar (TED) spread and the Financial Stress Index, were nowhere near their 2008 levels. We shouldn’t let the Fed get away with using another financial meltdown to justify its policies.
If it were just a matter of the Fed changing how it conducts policy, perhaps there would be little reason to worry. But things are much more serious than that. Simply put, the Fed’s new activities are dangerous. In economics, there is a clear distinction between monetary policy and fiscal policy. Monetary policy, which is the Fed’s job, is about liquidity. The Fed isn’t supposed to allocate resources, but rather help markets allocate resources for themselves. Fiscal policy, however, is about allocating resources. This isn’t the Fed’s job, yet by selectively directing credit, that’s what it’s doing.
Yes, Congress authorized many of these policies. But that makes things more dangerous, not less. Since the Fed is directly allocating resources with its credit policy, it’s effectively using a power the Constitution vests solely in Congress. This threatens the Fed’s independence. Once Congress realizes that the Fed can be used to engage in de facto fiscal policy, Congress has every reason to assert further control. A Fed dominated by Congress would no longer be a responsible steward of the economy. Instead it would become a partisan tool of whoever happened to be in the majority.
When kept within its proper limits, the Fed can do much good. But its activities in the wake of COVID-19 transgress those limits. With the Fed allocating credit, markets will come to rely, not on solid fundamentals, but largesse from central bankers. And Congress will find this source of funding, free from the messy politics of budgeting and taxation, too tempting to resist.
Unless the Fed reins in its operations, one of America’s most important economic institutions will become a source of chaos. It’s time for the Fed and Congress to stop their money mischief.
Originally posted on Real Clear Markets