Both the reasoned debate and the clamor over the re-confirmation of the Fed Chairman Ben Bernanke are now settling down. The focus is quite appropriately shifting to the work of the Fed. As the economy is trying to figure out how to pay for creating 8 million jobs in the coming years, the Federal Reserve, whatever future changes to the Federal Reserve Act (FRA) and to financial regulations the government may contemplate and eventually enact, takes center stage and the institution must be ready for it.
The Fed has the capacity under current law to be more interventionist in the financial sector than it has been. Some may argue that the Fed has already been sufficiently interventionist and was so in a manner which was highly non-transparent and this is what has caused the trouble. True. However, the intervention of the Fed has been mostly in areas of the financial markets which it does not regulate. To compound its travails over this discretionary intervention, it protected the institutions it was protecting by failing to disclose, until pressured, the details of how it was saving some large financial institutions such as AIG. The reconfirmation process has put the Fed on the path to coming clean publicly.
In areas of the financial markets which it regulates as a routine matter, the Fed is paying interest on one trillion dollars of excess bank reserves. It is money which has already been supplied but money that is going unused because, supposedly, the Fed is afraid of runaway inflation in a fragile economy. The Fed is indeed paid to worry about inflation. And it has to worry about it if and only if it lets out those trillion dollars with no strings attached because it would then have no control over how its member banks would use that money. They could misallocate it and increase inflation.
The Fed has the power under current law, far less extraordinary than what it has already done with those over which it has no regulatory authority, to ensure that those trillion dollars are not misallocated if it stops paying interest on the excess reserves. When banks do not earn interest on the excess reserves they choose to leave it in their Fed accounts of their own volition in return for nothing. This often happens when the excess reserves are small. This is how the federal funds market works: those with excess reserves lend them to those who are deficient, overnight, to maintain the legal minimum reserve balances in their accounts at all times. The demand and supply of these reserves determines the federal funds rate which the Federal Reserve decides to target 8 times a year.
Large excess reserves are indicative of the lack of demand for money elsewhere where it is really needed. It means, borrowers do not want to borrow from the banks or that the banks are risk averse and do not want to lend. At the moment it is perhaps both. Consumers do not want to borrow and firms do not want to invest. The banks are reluctant to lend because they are once bitten and twice shy. Formal credit constraints have also become more stringent since 2007.
Still, even though the desire to lend to only credit worthy borrowers is natural, and lending rates would more accurately reflect the underlying risks after the go-go lending days, it is necessary to increase the overall credit worthiness of the economy after the recent collapse. Some shaky debt may have to be rolled over and bad debts may have to be written off. This, the Fed can help do.
The kind of interventionism that the Fed needs is to literally look at each bank’s health and transfer the shaky debt on its balance sheet (assets of the bank) off its balance sheet, transparently, which is no different from social security and postal service accounting on the federal budget. The Fed’s bank supervisors must value those assets appropriately to provide the equivalent in cash without the Fed having to take those assets onto its books as it had done with the mortgage backed securities.
The condition for the Fed to intervene as such on a per member bank basis would be to obligate the bank to lend those funds to borrowers for certain types of consumption or investment which can take advantage of the current and perhaps future tax incentives that can create jobs: for example, borrowing for weatherizing homes with energy efficient windows, installing solar panels on the roof tops of both homes and business establishments, for greening the housing and commercial real estate markets in general, for the auto industry to retool to produce more energy efficient and low-emission vehicles and to help the financial markets raise capital for large projects such as the smart grid, high-speed rail, nuclear power expansion, and other major infrastructure improvements.
All of these can be accomplished with the trillion dollars of excess reserves and the continuing policy of providing cheap money to the markets for an extended period. To do so, the Fed will have to commit itself to creating the loan demand on the ground to produce the demand for the securities and derivatives based on those loans in the broader markets. It is no different from expanding the dynamics of the housing expansion before 2007 to many different areas across the economy, but in a more controlled and targeted manner to prevent overzealous and reckless unsupervised behaviors and risk concentration.
The Fed can even control the quality of credit default swaps (CDS) by temporarily suspending the private market for them, with prior Congressional approval, and issuing the CDSs itself by dictating the terms of their quality to repair the derivatives market and to standardize it for eventually transitioning all Over The Counter (OTC) financial instruments to trade in regular exchanges similar to stocks and bonds. The Fed can become the economic equivalent of the Food and Drug Administration (FDA) of financial innovation.
With such close and sensible supervision to enable the financial markets to do what they do more responsibly, the Fed can repair its image of having been derelict in the past. It will also learn a great deal about the intricacies of how the financial markets it is charged with engaging actually work by trusting while verifying. It will be hands-on in repairing the monetary transmission mechanism to return it to its primary purpose of providing capital to the economy.
This will be an opportunity for the Fed to atone and to become competent enough to legitimately seek an expansion of its regulatory powers in the medium term over all of the various financial market activities, not merely commercial banks, by earning the necessary public trust after demonstrating that it can balance its supervisory responsibilities with its money supply function without inherent conflicts.
The Fed has the regulatory power to ensure, through supervision, that risk premia align themselves better with the underlying risk and to make its supervisory reports of financial institutions transparent and public to ensure that banks compete to preserve and enhance their reputation and not take risks, feeling comfortable that the Fed is protecting them from their deteriorating health as was the case with the recent AIG rescue.
It will have little to worry about inflation (or the value of the country’s currency) if it complements such balanced and transparent supervision with complete transparency on monetary policy. The exit strategy for the Federal Reserve must be a change in its monetary policy regime to an explicit inflation targeting range to clearly communicate to the markets not what the path of interest rates is going to be when it cannot do so for good reason, but to let the markets know explicitly what its maximum and minimum inflation tolerances are to help them guide their own business decisions relative to interest rate expectations. The Fed’s inflation targeting range must be subject to Congressional approval (through an amendment of the FRA) when it proposes changes.
No regime of inflation targeting would suffice if the financial markets expect the Fed to be their first resort to provide them with liquidity when exuberance turns to fear. These cycles cannot be dampened completely under the current elemental and overarching economic constraint of the flows and ebbs of economies even if the Fed regulates and supervises the markets better. The Fed can institute an interest bearing contingency reserve, in lieu of the minimum capital which is currently required to be held at the banks by the banks, which would be refunded to the financial institutions in the event of a prospective institutional failure or systemic crisis. Such a self-financed buffer to prepare for potential failures can ensure better risk management and restore the last resort lender function to the Fed by mitigating moral hazard.
Monetary policy transparency naturally lends the institution to making its public communications more open. There is no better model for the Fed to emulate in this regard than the United States Supreme Court. All 19 Federal Open Market Committee (FOMC) members must be permitted to vote in all of the FOMC meetings. The press and the public must be allowed to attend the staff presentations to the FOMC. The confidential, closed-door deliberations of only the FOMC members must be followed by the FOMC statement and a one-page explanation, in concurrence or in dissent, of the decision of every FOMC member, must accompany the statement and vote tally.
The Federal Reserve economic forecasts and data used in the staff presentations must be made available to the public along with the FOMC statement to encourage public debate about the Fed’s decisions both within the economics profession and outside, in real time, rather than rationing what the Fed wants the markets to know through calculated press contacts from the Board room.
A Federal Reserve which has nothing to hide and no secrets to hold in its temple, not unlike most of the rest of the United States government which is increasingly becoming more open to public participation, is a better Federal Reserve.
If it cannot be so as an independent agency of the United States Congress, perhaps it must indeed end, but in the Treasury to be its reformed self as a matter of law, because the nation needs its money even if it may not need the Fed.