Has the Federal Reserve Become Too Powerful?

by: John M. Mason

Is the Federal Reserve becoming too powerful? This question comes up following the events of the arranged marriage of Bear Stearns (NYSE:BSC) with JPMorgan (NYSE:JPM), and comes up following the Fed’s trading of U.S. Government securities for other securities of lesser credit held by securities dealers. It appears again after the Federal Reserve has created its new auction facility for bank reserves, which is in addition to its role as providing the “Greenspan put” to protect investors on the downside of an asset bubble.

There is also the role of providing liquidity to the financial markets when there is a liquidity crisis. The Fed also has responsibility for examinations of commercial banks and enforcing regulatory requirements, as well as many other responsibilities the Federal Reserve is charged with, including the check-clearing system.

Furthermore, the Treasury proposal for the modernization and strengthening of the regulatory system puts the Federal Reserve at the center of the new regulatory universe.

Then there is monetary policy. If inflation is “everywhere and at every time a monetary phenomenon” then the Federal Reserve has responsibility for conducting a monetary policy aimed at maintaining relatively stable prices.

There are two problems connected with this plethora of responsibilities. First, the different responsibilities can have different, even conflicting objectives. By resolving one difficulty, the Fed may be creating another difficulty that must be addressed by another one of its functions. As a consequence, the Federal Reserve may always be attempting to resolve something that it initiated itself in other actions. For example, how does the Fed avoid a financial crisis and constrain inflation at the same time?

Second, when difficulties occur, the public turns to the Federal Reserve as the “savior of last resort” regardless of what the difficulty is. The public is not turning to the Treasury Department, or the SEC, or any other branch of government. It is turning to the Fed as the only agency that can resolve the problems.

The Federal Reserve cannot be allowed to lose its focus! Over the past twenty years or so, nations around the world have discovered that central banks must be independent of its national government in the conduct of economic policy and the central bank must have inflation as its primary focus. While other central banks have taken on this approach to central banking and while many of them have accepted ‘inflation targeting’ as they primary operating function, the Federal Reserve System in the United States has moved in the opposite direction.

Jean-Claude Trichet, the president of the European Central Bank [ECB] stated on Monday that the ECB would set interest rates based on “no other considerations than the delivery of price stability in the medium term.” That is, the ECB cannot be counted on to set interest rates to help the Americans with their financial and economic problems or on anything else at the present time. The focus is on inflation because that is the responsibility of a central bank.

We, in the United States, must be careful going forward in what we ask of the Federal Reserve. Within the current environment there may be too much of a vacuum in other areas of the government to provide the Fed with much assistance in tackling the problems that lie ahead. However, we must beware of what power is given the Federal Reserve, for in adding more responsibilities to the Fed’s portfolio, people will only be causing the Federal Reserve to reduce its attention from the main thing it should be doing.

If this happens it will only create more problems for us in the future.