In a figurative sense, when the Federal Reserve System says “Jump, ” the financial world asks, “How high?”
But why? Just what is the Federal Reserve, and why is it held in such high esteem? The short answer is that it is powerful and influential — it controls the nation’s money supply and interest rates.
Although it does not technically set the prime rate, the Federal Reserve does determine the other, lesser-known rates on which the prime rate is based. The prime rate, the lowest rate that banks charge commercial customers, is a major factor in the economy, because it serves as the basis for rates on all consumer loans, as well as credit cards.
With more than 19, 000 employees in its 12 branches, the Federal Reserve made more than $100 billion in profit in 2016. That equaled the profits of Apple, J.P. Morgan Chase and Berkshire Hathaway combined.
The Federal Reserve System — or the Fed, as it is often called — was created in 1913 as an independent body following more than a dozen major bank panics and recessions dating back to the nation’s infancy. It was established to use monetary policy to bring more order to the economy and put an end to the repeated boom-and-bust cycles, although it has not always been able to do that.
The Federal Reserve reports neither to Congress nor the president of the United States, who appoints the Federal Reserve chair. In part because of its clout and autonomy, the Fed has its critics and always has.
“The Fed is a profoundly undemocratic institution staffed by a bunch of unelected, arrogant bureaucrats, ” says Joe Salerno, a professor of economics at Pace University in New York and academic vice president for the Ludwig von Mises Institute in Auburn.
Like it or not, the Federal Reserve is under fire for keeping interest rates too low for too long.
One of the Federal Reserve’s key interest rates is the Fed Funds Rate, which is the rate at which banks and other depository institutions loan money to each other. The Fed Funds Rate, along with the Fed’s Discount Rate, essentially determine the prime rate set by banks. The Fed Funds rate was at near-zero from 2009 through most of 2016 and now is in the 0.75 to 1 percent range.
Despite the low rates, the economy is still underperforming, critics say. “We haven’t gotten back to a normal interest rate environment, ” says James Barth, a finance professor at Auburn University. “A lot of older people with savings accounts have suffered because of the low interest rates. Normally they would spend some of the interest they get on those savings, and that could help the economy. But they’re getting nothing right now.”
But low interest rates are the “new normal, as least for now, ” says Mekael Teshome, an economist at PNC Bank in Pittsburgh. Lower interest rates are the result, in large measure, of slower growth in productivity and the labor force both worldwide and in the United States.
“The Fed is understanding, and many people are now understanding, that the long-term growth rate for the United States has come down over the years, ” Teshome says. “Productivity growth has slowed over time and labor force growth has slowed. We can debate why that’s happening, but that seems to be the general case.
“The 2018 potential growth rate of the economy will not be the same as it was in 2008 or 2000. For that reason, the appropriate interest rate is actually lower. A 2 percent interest rate is higher now than it was 10 or 15 years ago. The general public might be looking at what the economy used to be, but the Federal Reserve is looking at how the economy is evolving.”
David Altig, executive vice president and director of research at the Federal Reserve Bank of Atlanta, says that the Fed’s monetary policy is just part of a much bigger picture. As an example, he notes that the global slowdown in population growth is dramatically impacting labor force growth, which in turn affects productivity.
“That alone is going to bring much slower growth than we saw, say, in the 1960s, and that is a global story, ” Altig says.
“The Fed has a short-term role to play, and an important role for sure, but interest rates I think are going to remain low in a historical reference for a long time, and that won’t have to do with monetary policy. It has more to do with demographics.”
The Fed’s monetary policy works in tandem with private industry and the federal government’s fiscal policy, which covers the budget, taxes and other federal initiatives. But fiscal policy, especially in today’s dysfunctional Congress, doesn’t always support monetary policy.
Says Teshome: “There are many things that limited the effectiveness of monetary policy after the recession. Part of it was that the federal government, and even state and local governments, reduced their spending or slowed it down. So the stimulus from monetary policy was offset by austerity from the fiscal side, from governments. That’s part of the reason we didn’t see this massive ramping up of growth that people expected we would with near-zero interest rates.”
From Altig’s perspective, the most important question to address is how to spur productivity growth. “How we get from Point A to Point B on the productivity question is really tricky, ” he says. “Quite frankly, I don’t think there’s a consensus even among people who think really hard about this, people who are well-informed don’t know what the magic elixir is.”
Although he is critical of the Fed’s pre- and post-recession performance, Auburn’s Barth says the answer for economic growth is bigger than the Federal Reserve but the Fed cannot afford mistakes.
Fed fiscal policy — revolving around changes in interest rates — gets the attention of headlines, but Fed monetary policy — the amount of money the Fed circulates — is the much bigger question.
No matter how you slice it, the Federal Reserve’s post-recession monetary policies transformed its balance sheet into a monkey on its back. A simple explanation is that the Fed added unprecedented amounts of debt to its balance sheet while pumping more money into circulation to steady the economy. Immediately prior to the recession, the Federal Reserve had assets of $858 billion. But after the Fed’s quantitative easing, its assets jumped more than fourfold, to $4.24 trillion, by the end of 2009 and now total more than $4.5 trillion.
According to various accounts, the Federal Reserve bought “toxic” assets that included mortgage-backed securities, collateralized-debt obligations and credit-default swaps that couldn’t be sold in the secondary market, because they were essentially guaranteed to lose money. The Fed also bought large amounts of U.S. Treasury securities, all of which required more money to be put into circulation.
Now, the Federal Reserve has said it wants to reduce the size of its balance sheet in an orderly fashion. But that will be easier said than done and could easily hurt the economy.
“Whether reducing the size of its balance sheet is a problem depends on how the Fed’s actions evolve over time with the economy, ” says Mekael Teshome, an economist at PNC Bank in Pittsburgh. “It is risky, and the risk is if they reduce the balance sheet too slowly, inflation can get out of hand. If they do it too fast, (higher interest rates) could cut off expansion, and that is certainly a risk we are keeping our eye on. But I don’t think it’s possible at this point to just say the Fed is going to fail right away.”
The Federal Reserve has never had to reduce its balance sheet to this degree, so it’s basically in uncharted waters. Added to all this is uncertainty. President Donald Trump can replace current Federal Reserve Chair Janet Yellen in early 2018 if he chooses to do so, and there will be other high-profile vacancies to be filled at the Federal Reserve.
Charlie Ingram is a freelance contributor to Business Alabama. He is based in Birmingham.