Why We Need the Fed Now More Than Ever

by: Mark E. Bachmann, CFA

The world runs on mythology, and we should never sell short the power of myth. This is particularly true in finance because our system depends so utterly on public confidence. Confidence in American financial power is still one of the main anchors for the global economy, and at the foundation of American financial power stands confidence in the Fed. A certain cult of mystery has always surrounded the institution. It has been compared to a temple and its directors to ancient priests. Its workings are completely inscrutable to the general public and even evoke a degree of bemusement among economists who study it.

Such secrecy has consequences. The Fed has always had bitter enemies, tapping into a deep root of suspicion against centralized finance in America that extends back to the days of Alexander Hamilton. Oddly, critics on both the right and left have seemingly come to regard the Fed as the source of all economic evil in the country. Conservative Republican congressman Ron Paul wants to dismantle it, and he has found some of his most fervent allies among left-liberals. Leftish conspiracy theorist Ellen Brown, author of a recent book called Web of Debt, depicts the Fed on the cover of her book as a giant spider, no doubt sucking all the blood out of America’s poor and downtrodden. Chronic secrecy makes it possible for everybody to imagine the worst.

On the other side of the fence, the Fed’s boosters have in the past appeared to attribute benign Olympian powers to the bank. Prior the 2008 financial crisis, Wall Street analysts hung on every word emanating from the Fed, as though the tiniest shift in Fed policy had the power to determine how robust the next upward move in the stock market was going to be. Many observers considered the prolonged economic boom that largely overlapped Alan Greenspan’s eighteen-year tenure as Fed Chairman to be proof that America’s central bankers had finally mastered their science.

Then the crisis hit in 2008. True believers suffered a moment of cognitive dissonance from the fact that the all-powerful Fed could even have allowed such a collapse to occur in the first place. But when it did, the Fed was still the institution many instinctively looked to for salvation from the threatening abyss. Greenspan had retired two years earlier and Ben Bernanke was in the chair. Greenspan had done more than any previous Fed chairman to enhance the Fed's mystery aura. His famously convoluted sentences allowed people to imagine powerful processes at work behind him secretly facilitating America's steady roll of prosperity. Bernanke adopted a different style from the start of his tenure and tried to speak more clearly. But after the onset of crisis, he too labored to give the impression that Fed economists fully understood the causes of the breakdown and that indomitable machinery was somehow at work behind the scenes repairing the damage.

In fact, the real powers that the United States has delegated to its central bank are considerably more limited than is commonly believed. Putting aside the Fed's regulatory role, if one were to ask around to gauge popular notions about Fed powers, he or she would get a mix of generally vague answers. Some would simply shrug. Others, knowing a little bit, might say, well, the Fed controls interest rates. Others, thinking a little deeper, might say, well, the Fed controls the money supply.

While interest rates and the money supply are indeed at the core of the Fed's mission, the fact is that neither lies under the Fed's direct control. The main tools in the Fed's bag; its open market operations and the Fed Funds rate, provide only indirect leverage. With respect to interest rates, the Fed Funds rate anchors the short end of the maturity curve, but as we've learned recently, the simulative impact of the short rate reaches a point of diminishing returns as it approaches zero. Long rates are driven by the markets, and any attempt to control them can be like trying to guide a long, heavy rope by wiggling it's tip. Long rates move in rogue patterns, especially when bond investors lose confidence in the future.

The money supply too moves only indirectly in response to Fed actions. It's the private banking system that controls the supply of circulating money, through the cyclical process of extending and retiring loans. The Fed manages only the level of base reserves in the system. The limitation of this power was apparent recently when the Fed pumped excess bank reserves up to record levels, only to watch helplessly as bank lending failed to grow sufficiently to support robust business expansion or employment.

The Fed remains the most important single economic institution the country, despite these limitations. The public's tendency to imagine even greater powers behind the scene is mostly salutary, because it helps sustain confidence at times when the disappearance of confidence could be catastrophic.

Investors should pay careful attention to attempts currently underway in the United States Congress to demand greater accountability of the Fed. While there is on the surface nothing wrong with accountability, the next step would likely be an effort to subject the Fed to greater political control. The Fed's critics on the right would, given the opportunity, seek ways to re-impose a gold standard or some other form of commodity backing for the Dollar. Left-wing antagonists, for their part, dream of putting the power to create fiat money directly into the hands of politicians, who could then fund government programs without cumbersome reliance on the bond market. Either of these extremes would have deeply destabilizing consequences for the financial markets.

Whatever its flaws may be, the American Federal Reserve System does a reasonably good job of balancing the need for centralized monetary authority against the benefit of decentralized control. We need the myth of the Fed's omnipotence, but should be thankful we're not subjected to the reality.

Disclosure: No Positions