North Carolina Cooperative Extension

You Decide: Are We Asking Too Much Of The Fed?

By Dr. Mike Walden | Mar 20, 2017

news. With the economy improving and the stock market soaring, the Fed is expected to increase short-term interest rates several times in 2017

Yet the Fed and its policies have not been held in high regard by many. Some say the Fed has been trying to do too much. Indeed, some even say the Fed’s policies have been harmful. Let me try to explain and then let you decide.

First, a little background is needed. The Fed is one of the most powerful institutions in the country, especially regarding the economy. Created over a century ago as the “lender of last resort” to banks, the Fed’s original mandate was to prevent panic by depositors when widespread fears struck the economy. By keeping banks afloat during economic hard-times, depositors wouldn’t withdraw their money and credit markets would continue functioning.

The Fed was very active in pursuing this goal during the Great Recession. Funds were provided to financial institutions experiencing trouble, loans were directly purchased by the Fed and the key short-term interest rate controlled by the Fed was lowered to zero percent. The purpose of the last policy was to motivate borrowing and spending.

The economy did stop its free-fall in mid-2009, and the aggregate economic measures have been improving since then – but at a slow pace. Although the Fed was late to the game in perceiving the seriousness of the economic crisis (as were most economists, including yours-truly!), most professional evaluations say the Fed’s intervention was crucial to keeping a lid on the damage caused by the Great Recession.

So why has the Fed been under fire? While there are some who question the need for a Fed at all – arguing private bank insurance could prevent massive withdrawals from banks during economic downturns – others support the Fed’s basic mission but say it has moved beyond that mission and is trying to micro-manage the economy.

Specifically, critics point to two actions the Fed continued long after the immediate crisis of the Great Recession passed. First, the Fed purchased financial assets well after the economy had moved into recovery phase. The Fed’s portfolio of financial investments now stands at $4.5 trillion, up from under $1 trillion prior to the Great Recession.

Critics argue it is not the job of the Fed to hold investments of this size. They also worry how the Fed could reduce their holdings without disrupting financial markets.

The second Fed policy that has been questioned is their control of short-term interest rates. While many could justify a zero percent rate during and shortly after the Great Recession, the Fed kept the rate at zero percent until December 2015, over six years after the economy resumed growing. Even today the rate is under one percent.

One obvious casualty of these low interest rates has been savers in low-risk investments, like US government securities and bank certificate of deposits (CDs). With inflation still continuing, a zero or near zero investment interest rate means savers are losing money in terms of purchasing power of their investments.

 

Another concern is that the super low interest rates have motivated investors to pour money into the stock market and other higher risk investments, perhaps ignoring the fundamentals behind those investments. The Dow-Jones Industrial Average has risen over 200 percent from its recent bottom in 2009. While some of this gain represents improved business conditions, part of the rise could represent a “sugar high” from the low interest rates.

 

The worry is what happens when interest rates return to some level of normalcy? Will the stock market drop? And what about the lost wealth of those savers who continued to invest in bank CDs and similar investments? Clearly their future financial goals, such as retirement, have been adversely affected.

 

In a way, the Fed can’t be blamed for its actions. In addition to the Fed’s original objective of supporting the financial system in times of crisis, Congress later mandated the Fed to pursue policies resulting in “maximum employment,” generally interpreted to mean a low unemployment rate. So the Fed can argue it keeps its financial asset buying program and low interest rate policy going until the unemployment rate reached “low” levels – generally thought to be in the four percent to five percent range. This didn’t happen until last year.

 

In my humble opinion, what this all means is that Congress needs to have a debate on what the guidelines should be for the Federal Reserve. Do we only want the Federal Reserve to intervene in the economy when the financial system is in trouble? Or do we also want the Fed to try “fine-tuning” the economy – that is, keeping the unemployment rate and the inflation rate within certain ranges?

 

There are now three openings on the governing body of the Federal Reserve. President Trump has an opportunity to fill these positions with the confirmation of the Senate. The four-year term of Janet Yellen, the current chair of the Federal Reserve Board of Governors, expires at the end of January, 2018. So if we’re going to have a debate about what the Fed should do, now is a great time.

 

It took our nation a long time to agree to establish a central bank like the Federal Reserve. This is understandable as the Fed has an enormous amount of power over our economy and daily lives. With controversy over the Fed’s policies since the Great Recession, maybe it’s a good time for you to help decide what the Fed should – and shouldn’t – be able to do!

 

Walden is a William Neal Reynolds Distinguished Professor and Extension Economist in the Department of Agricultural and Resource Economics at North Carolina State University who teaches and writes on personal finance, economic outlook, and public policy.

 

 

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