The Fed Says It Stabilizes the Economy. I'm Skeptical.
Before, during, and after the 2007–09 financial crisis, the masthead of the Federal Reserve Board’s main webpage included the following assertion right below its name at the top of the page:
The Federal Reserve, the central bank of the United States, provides the nation with a safe, flexible and stable monetary and financial system.
This statement is still there today. Can we all breathe easier now? Maybe not, if we endured one of the worst financial crises ever while the Fed was championing itself as a source of stability.
Rebranding to Inspire Confidence
Curiously, the board changed the wording of the statement at the top of the main page of its website during 2007, amid the onset of the 2007–09 disaster. Back in January 2007, the internet archive Wayback Machine shows the following saying to the right of the board’s name at the top:
The Federal Reserve, the central bank of the United States, was founded by Congress in 1913 to provide the nation with a safer, more flexible, and more stable monetary and financial system.
In other words, at the beginning of the year, the assertion was an opinion of what Congress intended, not what the Federal Reserve said that it provided in reality. By the end of 2007, however, the statement had taken on the more assertive, confidence-inspiring tone it has today. The Fed has advertised itself as a sufficient condition for financial stability, period—not simply as a means by which Congress tried to promote that difficult goal.
This helps to explain why the Fed’s forecasting failed so dismally before 2008–09. When advertising itself as a source of stability, it may have been hard to predict what ended up being one of the worst financial crises in our nation’s history.
We should try to learn lessons from history, including this one. Can we take for granted the Fed’s continuing claims to be a guarantor of stability, today? Not just in terms of the Fed’s role in stabilizing and/or bailing out large financial institutions, but for a stable price level?
In this light, the Fed’s more recent claims that inflation threats are “transitory,” and that it has the tools to manage higher inflation if it arises may not be so comforting. And the factors undermining confidence in the Fed’s credibility for inflation fighting are related to its claims to serve as a source of financial system stability.
The Financial Stability Report: Avoiding Liability for Crises
Back in 2010, reeling from the political effects of the 2007–09 financial crisis, Congress passed the 849-page “Dodd-Frank” legislation. It was signed by President Barack Obama with a statement that the law was intended “to make sure that a crisis like this never happens again.”
The first section of Dodd-Frank created a new Financial Stability Oversight Council (FSOC). The first listed member of the FSOC was the secretary of the Treasury and the second was the chairman of the Federal Reserve Board of Governors. The law made the Treasury secretary, not the chair of the Federal Reserve, the chair of the FSOC. And the law created ten voting members, with the chair of the Fed holding only one of those votes.
The law directed the FSOC to annually report on financial market developments with “potential emerging threats to the financial stability of the United States,” including developments relating to “accounting regulations and standards.”
In 2011, the FSOC issued its first annual report. That report listed a financial system that was “less vulnerable to crisis” first among three elements of the “stronger, more resilient financial system” the FSOC said the law was trying to promote. In turn, the first of six elements of policies to achieve those ends was “tougher constraints on excessive risk taking and leverage across the financial system.”
Before 2011, and indeed before 2008, the Federal Reserve had assumed the lead role on such matters. That may help explain why, beginning in 2018, the Fed began publishing its own Financial Stability Report. The Fed doesn’t have a specific directive from Congress for this report, and it has justified enlightening the rest of us on financial stability developments as a means for promoting increased “transparency and accountability for the Federal Reserve’s views,” given that “promoting financial stability is a key element in meeting the Federal Reserve's dual mandate for monetary policy regarding full employment and stable prices.”
But the Fed has already long reported semiannually on its performance in meeting Congress’s dual mandate in the Humphrey-Hawkins testimony, raising the question of whether this report is necessary or merely a means by which the Fed is trying to defend and promote its leadership role.
The latest version of the Fed’s Financial Stability Report arrived in May 2021. The Fed distinguishes “shocks” from “vulnerabilities,” with a view to promoting a financial system capable of performing intermediation services during and after the arrival of difficult-to-predict or control “shocks.” In making this distinction, the Fed risks a perception that is trying to wash its hands of responsibility for creating the conditions under which shocks arise.
In all of its financial stability reports issued since 2018, the Fed has reviewed developments in four categories established for its “vulnerabilities,” including asset valuations, funding risk, borrowing by businesses and households, and “leverage in the financial sector.” For the last category, the Fed has been tracking leverage among banks, broker-dealers, insurance companies, and hedge funds—but it has refused to look at itself in the mirror. The financial stability framework does not include leverage for the Federal Reserve Banks in monitoring vulnerabilities.
Doing More Harm Than Good
In its latest weekly consolidated balance sheet for the twelve reserve banks, the Fed reported $8.1 trillion in total assets, funded by $8.0 trillion in liabilities and $36.9 billion in capital. That’s a massive amount of leverage for an $8 trillion dollar “company,” one whose assets and liabilities quadrupled from 2007 to 2019, and have since doubled with the arrival of the pandemic and the impact of government lockdowns on the economy.
Assume a widely unforeseen but significant increase in inflationary expectations arrives in coming months. That might qualify as a shock—under the Fed’s framework for financial stability, anyway—especially given the implications for the prices of trillions of dollars of “risk-free” Treasury bonds, as well as longer-term securities issued in the private sector. In turn, widespread losses in bond prices would have immediate consequences for the finances of the Federal Reserve Banks and the independent exercise of monetary policy.
In “normal” times, the Fed could try to manage rising inflationary expectations with contractionary monetary policy, selling bonds in open market operations with a view to drawing down reserves in the financial system. Given its high leverage, however, selling bonds could generate significant losses for the Reserve Banks. These would wipe out its reported capital were it not for an accounting change the Fed made to its own accounting standards a few years ago.
In 2014, Marvin Goodfriend identified Federal Reserve quantitative easing as a “bond market carry trade,” one that accumulated risk on the Fed’s balance sheet and threatened the independent exercise of monetary policy given the Fed’s implied reliance on the US Treasury and future fiscal policy. Goodfriend argued that the Fed should retain more of its earnings and build up its capital to reduce its leverage risk and bolster the credibility of its monetary policy.
In this light, the Fed’s ongoing efforts to monitor and advertise its ability to manage financial market stability bring to mind a prophetic article written by George Kaufman and Kenneth Scott in 2003, titled “What Is Systemic Risk, and Do Bank Regulators Retard or Contribute to It?,” Kaufman and Scott decried the moral hazard implications of government safety net policies, concluding that “many bank regulatory actions have been double-edged, if not counterproductive,” and called for significantly reducing government’s backup role in the financial sector.
Congress should explore a fundamental reexamination of that backup role today.