22 December 2008
2008: The Year the Fed Steamed into Uncharted Waters
U.S. central bank reinvents itself in response to an unparalleled crisis
Washington — Extraordinary policies pursued by the Federal Reserve to jump-start credit markets and stimulate economic activity may define the U.S. central bank’s role in the economy for years to come, according to analysts.
In 2008, the Federal Reserve, together with the Treasury Department, spearheaded efforts to pump billions of dollars into some financial institutions in exchange for poorly performing securities or preferred stock, and has helped arrange mergers and acquisitions of others. It has entered currency swaps with other central banks to meet international demand for U.S. currency and coordinated interest-rate cutting with those banks to help stimulate a slowing global economy.
Allan Meltzer, a professor of economics at Carnegie Mellon University and author of a book on the central bank’s history, said that in the past year, the central bank expanded its role in the economy more than during its previous 94 years. In his book he describes how monetary policymakers had been cautious throughout those years in using their authority. For example, during the 1921 recession, the Fed, as it is known, refused to rescue farms, arguing their difficulties were not its business.
The Fed’s 2008 actions often were presented by the media as unprecedented in their assertiveness, scope and magnitude.
The extent to which the central bank took private debt on its balance sheet in 2008 is indeed unprecedented, said Robert Hetzel, a senior economist at the Federal Reserve Bank of Richmond (Virginia) and the author of a history of the Federal Reserve system.
The Fed’s balance sheet has gone to $2.3 trillion in mid-December from around $960 billion at the beginning of 2008, according to the bank.
Aggressive interventions in private markets — from an insurance conglomerate to an investment house to a mortgage giant — prompted The New York Times to call the central bank somewhat ironically the investor of last resort, a riff on the Fed’s traditional role as the bank lender of last resort.
An unusually deep and broad crisis has rendered the Fed’s traditional policy tool — setting key interest rates — less effective. Having exhausted its firepower by bringing the federal funds rate down virtually to zero, the central bank reached for yet another unorthodox measure. On December 16, the Fed made public a policy commitment: to pump more money into the system as long as it regards it as necessary.
“The only time in their history [policymakers] did something similar was in 1942, when they committed to maintain short- and long-term interest rates at a certain level and stayed with that until 1951,” Meltzer said.
Bold Fed actions have created controversy. Fed chief Ben Bernanke and Treasury Secretary Henry Paulson have been criticized for taking action to rescue some financial institutions while letting others collapse.
Some critics have slammed the Fed for starting interest-rate cuts too late, for rewarding excessively risky behavior in the market, and most recently for “gambling with taxpayers’ money.”
In a September article, Richard Timberlake, a scholar at the Cato Institute, a libertarian research group, said the central bank should stick to maintaining “absolute stability in the average of money prices” because otherwise it destabilizes the most effective distribution of resources throughout the economy and invites “all kinds of future monetary catastrophes.”
But the focus on inflation has not been a uniformly accepted practice of the Fed. Hetzel, in his book, cites economists who, until the 1970s, argued that fighting inflation was not the Fed’s business or that inflation could not be reduced significantly.
Today, Hetzel said, the jury is out on whether the policymakers should focus on credit flows or money growth to mitigate the effects of the economic cycle. The central bank can use its asset-acquisition policy to influence either.
“The results of the current policy actions will help define the appropriate role of a central bank in the future,” he said.
Meltzer, who was among the Fed’s critics before the severity of the current crisis became apparent, now praises its actions. “They have been very inventive and creative in finding ways to respond to problems in the market,” he said.
But once the economy begins to recover, the Fed must start unwinding security holdings and drain cash from the economy. At that time, the bank may find risky securities on its books difficult to sell.
President-elect Obama said reforming the financial regulatory system will be one of his first legislative moves once he takes office on January 20, 2009. He also will have an opportunity to fill three vacancies on the Federal Reserve’s governing body.
No matter what the president and lawmakers decide, experts say, the new strategy devised by the Fed is almost certain to ensure its outsized role in the economy for years to come.
“There is no exit strategy from this entanglement, anywhere,” Credit Suisse chief economist Neil Soss wrote to clients in an early-December newsletter.
For information on the central bank’s early history, see “U.S. Central Bank Benefits Self-Regulating Economy,” and for more on its operations, see “U.S. Central Bank Works to Smooth Business Cycle.”
