A Dangerous Man?
Understanding the power of the Fed
At some point in the next few months, President Biden must decide whether to re-appoint Jerome (Jay) Powell as chair of the Fed. Mr. Powell was appointed to the Fed Board of Governors by President Obama in 2012 and was elevated to the chairman’s role by President Trump in 2018. Several other seats on the Board of Governors will also become available in the coming months, including those held by Richard Clarida (Vice-Chair) and Randal Quarles (Vice-Chair for Supervision), both Trump appointees.
Senator Elizabeth Warren (D-MA) has already made clear that she intends to vote against Chair Powell, calling him “a dangerous man to head up the Fed”. “The elephant in the room is whether you’re going to be renominated,” said Ms. Warren, looking down at the Fed chair during a Senate hearing earlier this week. “Renominating you means gambling that, for the next five years, a Republican majority at the Federal Reserve, with a Republican chair who has regularly voted to deregulate Wall Street, won’t drive this economy over a financial cliff again.” [For more on this story, read here.]
I have great respect for Senator Warren, as I do for the candidate she would probably like to see appointed as the next Fed chair, Lael Brainard. Senator Warren has for many years served as a strong advocate for certain “progressive” views that don’t always get a full hearing and I think she is well placed where she is, in the US Senate representing a blue state (MA). And as a member of the Senate Committee on Banking, Housing and Urban Affairs, Senator Warren has regularly pressed the Fed on important topics relating to financial regulation and consumer protection, including with respect to the customer account scandals at Wells Fargo. I do not share Senator Warren’s views of Mr. Powell’s stewardship of the Fed—she has stated publicly that she will not vote to reappoint him—but I do think she is right to focus on the Fed’s role in regulating and supervising banks and other financial institutions.
Many people think the Fed’s sole function is to manage monetary policy and set interest rates. And this is certainly an important part, arguably the most important part, of what the Fed does. But the Fed has responsibilities that go well beyond monetary policy, with great power to influence the stability not only of our economy but also our financial system. These other powers of the Fed are not well understood by many, and so I propose that we all spend a few minutes refreshing our understanding of the Fed, starting with some basics.
What is the Fed? The Federal Reserve System is the US central bank. It is a government agency, not a private or state-owned bank. The Fed’s counterparts internationally include the Bank of England, the European Central Bank, the Swiss National Bank, the Bank of Japan and the People’s Bank of China. The Fed is the single most important financial institution in the world, for reasons that I will explore below. All of you considering careers in finance, particularly those of you planning to work in banking or asset management, must have a sound working knowledge of the Fed. And for the rest of us, a basic understanding of the Fed will help us better exercise our rights and responsibilities as informed and engaged citizens in these turbulent times.
What does the Fed do? The Fed, like most central banks, has two primary missions: (1) to maintain macro-economic stability, ie steady economic growth with low and stable inflation plus full employment; and (2) to maintain financial stability, facilitating the smooth operation of the national banking system and capital markets while avoiding financial panics and crises. The Fed has three primary sets of policy tools which it uses to fulfill these two missions: (a) monetary policy, ie the regulation of interest rates (and historically the money supply) to influence spending, production, employment and inflation in the real economy; (b) the provision of liquidity (short-term loans) to financial institutions to maintain the smooth operation of financial markets and to serve as a “lender of last resort” when needed in times of financial stress or panic; and (c) financial regulation and supervision, curbing financial institution excesses and maintaining public confidence in the integrity of the banking and financial system.
Understandably, press coverage of the Fed usually tends to focus on monetary policy: “Will the Fed raise rates? When will it scale back QE? Are we in for another ‘taper tantrum’?” These are important topics and they get a lot of well-deserved press attention. In times of financial stress, such as 2008 and 2020, the Fed’s liquidity provisioning also becomes increasingly important and newsworthy: “Fed floods the markets with liquidity. Fed intervenes to stabilize repo market. Fed to lend $2tn to support the economy.” Financial regulation and supervision is generally a lot less exciting than monetary policy or financial crisis management and it doesn’t often get the coverage it deserves in the non-financial press. But as is evidenced by the press coverage of Senator Warren’s harsh critique of Chair Powell, Congress also cares very much about the Fed’s financial supervisory and regulatory actions, and so should we.
How is the Fed structured? The complex structure of the Federal Reserve System is one that could only have been designed in Washington DC. It is the classic result of partisan political compromise, a story well told in Roger Lowenstein’s excellent book, America’s Bank. But to simplify things (a bit), there are three principal Fed entities with which we should all be familiar.
First is the Federal Reserve Board of Governors, of which Jay Powell is the current chair. As you might imagine, the Board of Governors is the governing body of the Federal Reserve System, which sets or approves most Fed policy. The seven governors are appointed by the President and approved by the Senate for staggered 14-year terms. Presidential appointment and Senate confirmation is also required for certain board roles, including that of the chair and vice-chairs. These are the positions that President Biden will fill in the coming months, with Senate confirmation.
Less well known among the general public are the regional Federal Reserve Banks, which are the operating arms of the Fed. These are located in twelve cities across the US, each of which has its own particular functional responsibilities. The most notable of the regional Federal Reserve Banks is that in New York, known as the NY Fed, which supervises many of the country’s largest banks and conducts the Fed’s various capital market operations. [If you saw the film Too Big to Fail, the Tim Geithner character (played by Billy Crudup), was President of the NY Fed and he was one of the triumvirate of senior policymakers trying to manage the financial crisis, along with the Fed chair Ben Bernanke (Paul Giamatti) and the Treasury Secretary Hank Paulson (William Hurt.] The presidents of the regional Fed banks are selected by the regional bank boards of directors, and approved by the Fed Board of Governors. Two of these positions are now open due to the recent resignations of Federal Reserve Bank presidents Rosengren (Boston) and Kaplan (Dallas), following allegations of improper share trading activity. (For more on this trending story, read here.)
Finally, there is the Federal Open Market Committee (FOMC), which determines and oversees the implementation of monetary policy, including setting the target Fed Funds rate. When “the Fed” meets to decide on monetary policy, it is the FOMC that we are talking about. All seven Fed Governors serve as permanent members of the FOMC, along the president of the NY Fed. They are joined on the FOMC by a rotating group four other Reserve Bank presidents, selected annually.
What do we mean by Fed “independence”? By law and by custom, the Fed is “independent” of the US government in certain respects, most notably in the setting of monetary policy. Fed governors are appointed for staggered 14-year terms and neither elected officials nor members of the Executive Branch Administration are allowed to serve. The Banking Act of 1935 established the FOMC as a separate legal entity and removed the Treasury Secretary from the Fed Board of Governors, greatly enhancing the legal independence of the Fed. The Fed’s monetary policy independence was further reinforced as a result of the Treasury-Fed Accord of 1951, which separated the management of government debt (a Treasury obligation) from the management of monetary policy (a Fed obligation).
To say that the Fed is legally “independent” does not mean that the Fed is immune to political oversight however. The Fed is a government agency, created by act of Congress, and it must comply with all relevant federal laws, which can always be changed by legislative action. The Fed is also subject to express Congressional oversight, including by the Senate Banking Committee on which Senator Warren sits. But there is a difference between appropriate political “oversight” and inappropriate political “pressure”, particularly with respect to monetary policy. When Senator Warren questioned and critiqued Chair Powell about financial regulation during a recent Senate committee hearing, this was a clear example of appropriate “oversight”. But when President Trump tried to strong-arm the Fed into cutting interest rates to facilitate his own personal political objectives in an election year, this was viewed by many as a violation of the spirit and tradition of Fed independence. Of course President Trump was not the first or only US president to attempt inappropriately to pressure the Fed—far from it—but we should all understand the rationale for Fed independence and insist that our elected representatives respect it. Important traditions die when we do not protect them, in this and other important areas of our public life.
Tell me more about the history of the Fed. The Federal Reserve System was created by act of Congress in 1913 after a series of severe financial crises, most notably the panic of 1907, which was resolved by private action of a group of private New York bankers led by JP Morgan. Those of you who have studied 19th century US history will know that we had a very disjointed and dysfunctional financial system before the creation of the Fed, particularly in the second half of the 1800s. [For a colorful review of this period in US history, read Scott Nelson’s book A Nation of Deadbeats.] America’s previous attempts at creating a central bank (of sorts) had failed, with both the First Bank of the United States and the Second Bank of the United States having had their charters revoked (or not renewed) by partisan Congressional action under Presidents Madison (1811) and Jackson (1836).
The creation of the Fed in 1913 was also a highly partisan affair, as recounted in Lowenstein’s book. And the early years of the Fed were not without incident or political controversy. After managing its way more or less successfully through WWI and its immediate aftermath, the Fed failed its next big challenge in the late 1920’s and early 1930s, when a series of inept actions by the Fed contributed greatly to the longest and most severe economic depression in US and global history. During the 1930’s the FDR administration and a Democratic controlled Congress transformed the Fed and the US banking system through a series of bold actions, including the creation of the FOMC, the removal of the US Treasury Secretary from the Fed Board of Governors, the separation of commercial and investment banking (the Glass-Steagall Act), the creation of deposit insurance and the Federal Deposit Insurance Corporation (the FDIC) and suspending the gold standard.
During the 1940s, the Fed was again challenged with the advent of World War II. Working closely with the US Treasury, the Fed kept interest rates low in order to subsidize the financing of the war. This joint effort to manage the level of interest rates and the cost of government debt was successful from a fiscal perspective, but the continuation of the low interest rate peg and the associated monetization of US Treasury debt by the Fed contributed to a substantial rise in post-war inflation. It also created divisive tension between the Fed and the Treasury during the Korean War. This culminated in the so-called “Treasury-Fed Accord of 1951”, which separated the management of government debt (a Treasury obligation) from the management of monetary policy (a Fed obligation), enhancing the Fed’s independence and laying the groundwork for the modern Fed.
Following the Korean War, the Fed took on additional responsibilities with respect to bank regulation, most notably pursuant to the Bank Holding Company Act of 1956. The late 1950’s and early 1960’s were generally a benign period economically, with strong post-war growth in the economy, generally full employment and stable prices. But this economic situation changed in the mid to late-1960s, with growing inflationary pressures generated by deficit government spending to finance the Vietnam War and the so-called “war on poverty”. This continued into the 1970s when the US (and the world) suffered two large “oil shocks”, the first resulting from the OPEC embargo following the Yom Kippur war and the second the result of the revolution in Iran. By the end of the 1970’s, the US economy was in the tank, unemployment peaked at 9% or so, and inflation was running in double digits.
The Fed finally got a handle on inflation during the tenure of chairman Paul Volcker (1979-87) when it raised interest rates to nearly 20%, throwing the US economy into severe recession but also breaking the back of high inflation expectations and laying the groundwork for the longest period of peacetime economic expansion in US history, which began towards the end of his tenure. In my view, Paul Volcker was the greatest Fed chair for all time, and this is why.
Alan Greenspan (1987-2006) is regarded by many as a great Fed chair, mostly because of the strong and stable performance of the economy during his long tenure (the so-called “Great Moderation”). But the Greenspan legacy has suffered over the years, particularly since the financial crisis of 2008, which some attribute in part to Greenspan’s almost religious zeal for financial deregulation (he was a devoted fan of Ayn Rand) and the Fed’s lax supervision of the banking industry during his tenure. (Greenspan himself has admitted that some of this criticism is valid.) I think Greenspan can also be criticized for his propensity to use the policy tools of the Fed to stabilize volatile capital market conditions and support the stock market, repeatedly rewarding speculative risk taking and contributing to dangerous amounts of moral hazard embedded in our financial markets. (This phenomenon is known as the “Greenspan put”).
The Fed’s most serious challenges in recent history, however, occurred during the financial crisis of 2007-9, when the US and global banking systems came perilously close to collapse, and again in 2020 with the global covid pandemic. In the first instance, newly appointed Fed chair Ben Bernanke and his Fed and Treasury counterparts managed their way somewhat chaotically through the global financial crisis with varying degrees of success, but not without significant political backlash and the creation of continuing strains in our financial system. During this period, the Fed implemented its controversial policy of Quantitative Easing and Congress responded to unpopular government bailouts of banks and other financial institutions by passing the excessively stringent Dodd Frank Wall Street Reform and Consumer Protection Act.
During 2020, the global covid pandemic again crashed the global economy, triggering unprecedented economic and financial responses from policymakers worldwide. Under the leadership of chairman Powell, the Fed again cut interest rates to zero, reactivated quantitative easing, flooded the markets with liquidity, reopened its USD swap lines with other central banks, and underwrote trillions of dollars of new lending to financial and non-financial institutions, expanding upon the Fed support programs implemented during the financial crisis under Bernanke and continued by his successor, Janet Yellen.
What Fed actions under Powell have been particularly controversial? I am not sure exactly why Senator Warren is as critical as she is of the Fed Board under chair Powell, although it is true that the Fed has recently rolled back some of the more onerous or cumbersome banking restrictions implemented a decade ago during the financial crisis. The most significant of these moves probably relate to bank capital and liquidity requirements, but I think it is fair to say that the US banking system is now better capitalized and with greater liquidity than at any other time in our recent history, so perhaps as bit of regulatory relaxation is not unwarranted. The Fed Board acts by consensus, generally with unanimous votes, but not in this case. Fed Governor Brainard, an Obama appointee with an excellent reputation for thoughtful service on the Fed, has for many years been the sole dissenter on these deregulatory moves. As a result she has won the support of the “progressive wing” of the Democratic Party, without I think alienating her colleagues on the Fed. But does this put her in line to succeed Chair Powell?
Will Biden Reappoint Powell? I have no idea, but if I had to bet I would say yes. The only real contender currently on the Fed Board is Governor Brainard, who in my view is a very solid candidate, but I think her support from the “progressive” wing of the Democratic Party may well kill doom her candidacy with moderate Democrats and of course with all Republicans. But I am no expert on DC politics, and I may well be wrong. Either way this should be interesting, so stay tuned.
What are your favorite books about the Fed? I am so glad you asked; central banking is such an exciting topic! I do not have access to my library at the moment, but by memory here as some of the books that I have recommended to students: America’s Bank (Lowenstein), Lords of Finance (Ahamed), The Fed and the Financial Crisis (Bernanke), The Alchemists (Irwin), In Fed we Trust (Wessel), After the Music Stopped (Blinder), Too Big to Fail (the film, not the book), and Crashed (Tooze). And of course we should not forget that 1873 central banking classic, Lombard Street (Bagehot).
Links:
Senator Warren calls Jerome Powell a “Dangerous Man”, NY Times, 9.28.2021
Should Biden Reappoint Jerome Powell? WSJ, 9.14.2021
Fed Leaders Rosengren and Kaplan to Resign following Trading Controversy, WSJ, 9.27.2021
About the Fed, FederalReserve.gov
Fed Independence, FederalReserve.gov
History of the Fed, FederalReserve.gov
Fed actions during the Financial Crisis 2007+, FederalReserve.gov
Fed actions during Covid, Brookings