Some Troubling Aspects of the Federal Reserve

The Federal Reserve (Fed), America’s central bank, controls the cost and quantity of money available to American banks, businesses, and consumers by manipulating interest rates through various monetary policy tools.

The Fed sets interest rates conducive to sustained economic growth and full employment levels. Increased employment levels bring more demand for goods and services and push prices higher.

If left unchecked, price inflation can creep into the economy, feed on itself, and become destructive and difficult to dislodge.

The Fed fights demand-driven inflation by curbing economic activity and dampening the job market through higher interest rates.

The Fed seeks to balance a 2 percent annual inflation rate with maximum employment (typically, a 4 percent unemployment rate). Piloting the economy to this state, however, is an inexact science.

The impact of the Fed’s interest rate changes occurs over time; given different crosscurrents, it is difficult to accurately predict the extent of interest rate change needed to bring about the desired change in employment and inflation levels.

And by the time the desired levels show up in economic data, the Fed might have overtightened or over-loosened the economy. And thereby risk recession or inflation.

Given the challenging nature of the Fed’s balancing task and the potential for making a policy mistake, which can cause economic pain, we would want the Fed to be almost infallible.

But that is not the case. There are some inherent problematic aspects to the functioning of the Fed, three of which I will highlight next.

1) Groupthink

The Fed comprises 12 regional Fed Banks, a seven-member Board of Governors, and the Federal Open Market Committee (FOMC). The FOMC, comprising seven governors and five regional Fed presidents, makes monetary policy decisions.

One would expect the 12-member FOMC of accomplished individuals to bring different perspectives and often disagree regarding policies that have far-reaching implications.

Surprisingly, there is almost no dissent regarding monetary policy decisions within the FOMC.

FOMC members appear to defer to the Fed Chair, the public face of the Fed.

Financial markets and the business press also see the Fed Chair as all-powerful and the dominant element of the FOMC.

What explains the unusual consensus at the FOMC?

First, the Fed is wary that dissent within might reduce its credibility with the securities markets.

Second, probably every Fed governor looks into the mirror and sees a future Fed Chair. To this end, the governor wants to be perceived as a team player and not as a maverick.

Third, FOMC members risk their reputations less by being wrong as part of the consensus than by being wrong and different from the consensus.

Not surprisingly, the Fed is criticized for groupthink, which impairs decision quality. For example, the Fed’s highly inaccurate forecast in the year 2021 of inflation in 2022 screams groupthink.

2) Delayed Response

The Fed lowers interest rates to stimulate the economy. In recent times, the Fed has lowered interest rates to near zero.

In debt-addicted America, there is nothing more intoxicating than cheap money. The American economy is a big debt-fueled party of excesses when money is cheap.

At some point, the Fed must start winding down the party, but it’s hard being a party pooper. More so given the composition and the potential for pushback from the party revelers.

The revelers are not a bunch of drunken sailors that a no-nonsense sheriff can haul away.

They are CEOs, billionaire hedge fund managers, contractors, entrepreneurs, private equity investors, legislators, and more. Even the President; no US president has ever complained about interest rates being low.

It is easier for the Fed to start stimulating the economy than slowing it.

When the Fed is lowering interest rates, it is easing economic pain but when it is raising rates it is causing economic pain, at least in the short run.

Accordingly, I believe the Fed is behaviorally biased to act late when it comes to tightening.

Tightening the economy late requires the medicine, interest rate hikes, to be more bitter. Unfortunately, low-income Americans are most vulnerable to the negative impact of rising rates.

3) Unbridled Power

Ironically, the Fed, the most powerful economic institution in the world, faces negligible countervailing power.

The president nominates the Fed Chair subject to confirmation by the Senate. That’s about it. The president and Congress cannot fire the Fed Chair for monetary policy decisions.

The entity that can rein in the Fed is the US Treasury market (see Notes). The Fed directly affects short-term but not long-term borrowing rates, which are driven by bond investors.

Bond investors consider future economic conditions, such as GDP growth and inflation, and anticipate future Fed actions regarding interest rates when they trade Treasurys.

Now consider the situation in mid-2021 wherein the Fed was fanning inflation when it should have been combating it.

In anticipation of high and stubborn inflation, the worst nightmare of bondholders, the bond market should, ideally, have sold off. The resulting increase in yields would have pushed borrowing costs higher and dampened economic activity. The bond market would have forced the Fed’s hand.

Rather than being proactive, the bond market generally followed the Fed’s actions and commentary and lived the Wall Street mantra of don’t fight the Fed.

One explanation for the bond market’s tame behavior comes from the expanded interventional role the Fed has taken via quantitative easing (see Notes) following the financial crisis of 2007-2008 and again in 2020 during the pandemic.

The Fed in its expanded avatar has made private bond investors insignificant.

Follow the FED

Most Americans perceive the U.S. president as the most influential American. However, they are probably all over the place in their perception of the second most influential American—not many have the Fed Chair on their mind.

The Fed has extraordinary authority. And it is mostly unchecked. The Fed’s interest rate changes affect businesses, households, and the U.S. government as well as commodities, currencies, and securities markets.

Given the impact the Fed has, there should be more widespread awareness of how it affects us. We need many more activist Fed watchers. And we need increased public scrutiny of the Fed.

A puncture of the hallowed status of the Fed is long overdue.

 

 

NOTES

There is research that refutes groupthink in the FOMC, but I don’t buy it.

The tremendous volatility in the bond market in 2022 (the second highest ever) suggests that the bond market has been somewhat clueless, so no wonder it followed the Fed.

Currently, the Fed is talking tough on its interest rate target. Thankfully, now the bond market is not on the same page as the Fed. Let’s see who turns out to be correct. I guess the market is a lot smarter than the Fed.

US Treasury Market

Besides consumers and businesses, the US government is a big borrower. The US government borrows money by issuing IOUs, called Treasurys, of different maturities. Depending on maturity, they are called bills, notes, or bonds. Colloquially “bond” is used as an umbrella term.

Treasurys are publicly traded. The outstanding value of US Treasurys is about the size of the US annual GDP. The huge Treasury market, through Treasury yields, tells us what investors think about the future state of the economy and interest rates.

Interest Rates, Bond Prices, and Bond Yields

When I buy a US Treasury, say a 10-year bond (technically called a note) with a face value of $1,000, I lend the government $1,000. Over the life of the bond, I will get a fixed interest payment each year, of $40, assuming the interest rate for the bond is 4 percent. After 10 years, I will get my loan of $1,000 back.

Let us say after two years, I want to sell my bond. In the interim, interest rates could have changed. Assume they have moved up; this means the newly issued 10-year offers a higher interest rate, say 5 percent.

If newly issued bonds offer a fixed annual payment of $50, you will not buy my bond because it provides a lower interest payment ($40 vs. $50 for the newly issued bonds). You would, however, purchase it if I sold it at a discount, say $935. You will get a lower annual interest amount, but when the bond term is over, you will get $1,000, which is $65 above your $935 purchase price. During the holding period of the bond, you will earn a current yield of 4.27 percent because you purchased the bond at a discounted price (40/935).

If you are still with me, you can see from the above example, when interest rates rose (from 4 to 5 percent), bond prices fell (from $1,000 to $935) and current yields rose (from 4 to 4.27 percent).

Inflation and Bonds

The Fed battles inflationary pressures by hiking interest rates. As noted above when interest rates rise, bond prices fall, and yields climb.

Thus, amid inflation, bondholders will own bonds whose prices are discounted and the values of the annual fixed interest payments are eroded due to inflation. Accordingly, bond investors are very sensitive to interest rate changes and inflation.

Quantitative Easing

Following the 2007-2008 financial crisis, the Fed broadened its purchases of financial assets. The Fed typically buys short maturities to set interest rates. But in extraordinary situations, as was the case in the great recession and the pandemic, a zero percent interest rate might not be enough to stimulate the economy. In such situations, the Fed has resorted to quantitative easing–it buys longer maturities and also riskier assets such as mortgage-based bonds to inject liquidity into the economy. In this capacity, the Fed has become more powerful than ever before.