The Fed At A Crossroads

I've long been worried about the future of the Federal Reserve Board, particularly as the pre-eminent monetary policy authority on the globe. That eminence was hard-won. The infant Fed stumbled badly in the Great Depression and was essentially a branch of the Treasury Department into the 1950s. With the so-called Treasury accords in 1951, it became, nominally, an independent agency that, unfortunately, continued to do political bidding - particularly under the tenure of Arthur Burns.

However, with the arrival of Paul Volcker as Chairman and the declaration by President Reagan that the Fed was off-limits, the Fed grew into a genuinely independent and admired agency. Of course there was still complaining over its policies and, frequently, little love between overseers like Henry Gonzales, but by and large the expertise and excellence of the Fed was unchallenged.

The independence evaporated in the financial crisis as the Fed and Treasury collaborated in a series of high-profile interventions to save or sell Bear Stearns, AIG, Merrill Lynch, and others. Indeed, in the aftermath of the crisis, the Treasury felt compelled to issue a public statement swearing that, honestly, really, the Fed was independent.

Its political immunity, however, was damaged. And it continued to be damaged by the Fed's "extraordinary" monetary policies that provided a ready purchaser of Obama Administration debt, managed the yield curve on behalf of the Treasury, and selectively funneled credit to the housing sector. However beneficial to the macroeconomy these may have been in the eyes of the Fed, they were gasoline on the fire for its critics.

Worse, however, was the fact that the Dodd-Frank reforms designated the Fed as its uber-regulator for the financial sector, giving it the job of enhanced regulation over systemically-important banks and non-banks alike. Through its Comprehensive Capital Analysis and Review (CCAR) the Fed micromanages the dividend and repurchase decisions of those banks. Through its Financial Stability Oversight Council (FSOC) responsibilities, the Fed has taken on regulating insurers while simultaneously developing some expertise in the insurance industry. Inevitably, these regulatory activities engender complaints that are appealed to Congress, which steadily assaults the Fed's expertise.

And now the dam has broken completely, with the Republican nominee tossing the Reagan dictum to the winds and attacking the Fed at every turn. Of course, there is good reason for concern about the future of the Fed as a respected, independent monetary authority, but attacking it from the presidential debate stage as no more than a political organization far oversimplifies its challenges and does considerably more harm than good.

On top of the external pressures, the new regulatory responsibilities seemingly have created a Fed divided that is unable to act cohesively and seems dead set on making it worse. Throughout the recovery, the Fed as a whole seems to have forgotten the traditional role of the banking sector as the transmission mechanism for monetary policy. Instead, even as it pumped reserves into banks, it pummeled banks with new regulatory requirements and an ever-shifting, costly array of regulatory initiatives. The Fed undershot its targets for growth and inflation, and this is hardly a surprise.

The regulatory zeal of the Fed appears unabated. Recently, it proposed that the Congress undo provisions of the Gramm Leach Bliley (GLB) Act that permitted commercial banks to engage in merchant banking activities. Why? Fed Governor Dan Tarullo's conversation with CNBC's Steve Liesman began with Liesman's observation that "they (banks) say this has not led to any additional risk in the banking system, and, second, it's just seen as regulatory overreach. More decisions from central planning so to speak in the banking system."

Tarullo responded with three arguments: (1) "First, the traditional separation of banking and commerce still has some potency, I think. The reasons for it still have potency." (2) "Secondly, even though a risk may not have matured to this point, because of the potential for, for example, tort liability that substantially exceeds the amount of an investment, that can go along with certain kinds of business, for example, minerals extraction or transporting oil." (3) "This is not an easy sort of thing for financial supervisors to oversee."

Let's think about these. (1) is the same reason that the rosy-review-mirror set wants to re-impose Glass Steagall separation of commercial and investment banking, even though there is no - zero - evidence that it contributed to the financial crisis. (2) says that banks could get sued - a shocker in litigious America - and that somehow they hadn't thought of this when they invested in a commodities venture. And finally, (3) is the open admission that the goal is to micromanage banks from the Fed.

The travails of the Fed through the crisis are real and a sufficient threat to its independence and excellence as a monetary authority. Its hubris and overreach as a regulator may be an even greater threat, but at least one that the Fed could rein in.