EDITOR NOTE: The Federal Reserve has long been an institutional pillar of our economy; for over a century. It’s easy to take it as a normal, if not necessary, part of our economy’s functioning. But have you ever stopped to question what it is exactly that they do, whether their objectives can be clearly defined, and whether their policies are helping or hurting the economy? For example, what does it mean to stimulate the economy? Is there really a measurable cause-and-effect relation between interest rates, price stability, and the employment rate? And when the Fed aims to stabilize price, which prices are being included or excluded? A simpler question: why is the cost of living rising while, according to the Fed, the inflationary environment remains concerningly low?
With all the history, lore and media spotlight the Federal Reserve receives, how many people stopped to ask: What is the Fed’s purpose?
According to their website’s FAQs, the Federal Reserve system exists to:
provide the nation with a safer, more flexible, and more stable monetary and financial system.
It aims to carry this out through free market intervention including:
influencing money and credit conditions in the economy in pursuit of full employment and stable prices.
While the method of operations may leave some questioning the efficacy of its ability to reach its goals, it’s still much different than what San Francisco Fed president Mary Daly told the Wall Street Journal, in a one-on-one interview on Thursday:
If you go back to our forefathers, in 1913 they created the Federal Reserve and created clear roles. The Federal Reserve’s job is to use the short-term interest rate and its asset-buying capabilities to stimulate the economy, accommodate and stimulate the economy, through the interest-rate channel, making it cheaper for households and businesses to buy and sell goods.
The problem with “stimulate the economy” is that it signifies very little, as all platitudes do. How much stimulation does an economy need? And whether they may over- or understimulate can hardly be articulated. Concluding the Fed makes goods cheaper is an untenable position to hold considering they seek to fight deflation. What is possible to explain are interest rates and asset buying. Once understood, the redundancy of the Fed is exposed.
The first tool is interest rates, in which there is either an ideal rate or not. If the position of an “ideal rate” is believed, the question to follow is: How is this calculated? With over a hundred years of experience, we still have yet to find a verifiable method. No one can prove why a 0.25 percent rate is preferred to 0 or 0.50 percent.
If there is no ideal interest rate, we must come to terms with understanding that the Fed has no business in setting benchmark rates for an entire nation, if not the entire world.
The second key tool is the “asset-buying capabilities,” the act of money creation for the purpose of buying real assets. This is an act that, if done by anyone except the Fed, would lead to lengthy prison sentences.
Similar to the notion of an ideal interest rate, there is no such thing as the “optimal money supply.” Like interest rates, if such a number exists, it still has yet to be proven. Money creation comes with side effects such as rising inequality, as those who receive the new money first have an advantage over those who receive it late, while allowing central planners to pick favorites. At $18.7 trillion, the M2 money supply has increased by over $3 trillion since the start of 2020. It appears to be on a path to growing exponentially!
Once understood there exists no ideal interest rate or optimal money supply, the Fed’s value to society gets called into question. Of course, there may be value to some members of society as Vice Chair for Supervision Randal K. Quarles said in a Q&A on Wednesday about the Treasury market:
It could be that “the sheer volume there may have outpaced the ability of the private market infrastructure to support stress of any sort there.”
In other words, the private market for treasuries can no longer function without the help (asset buying) of the Fed. Hardly shocking, considering the mortgage crisis was over a decade ago. Yet the Fed still buys mortgage-backed securities. And, like the Bank of Japan, which cannot exit the stock market, or the European Central Bank, which can never exit the corporate bond market, in 2020 the Fed entered territory it will never be able to leave, while simultaneously advancing in areas it never belonged in in the first place.
Originally posted on Mises Institute