The growing clout of central banks

By Christopher Papagianis
September 18, 2012

The Fed’s decision to begin open-ended purchases of Fannie Mae and Freddie Mac mortgage-backed securities comes on the heels of the European Central Bank’s decision to purchase unlimited quantities of short-duration government bonds across the euro zone.

The ultimate goal of the central banks’ action is to influence the prices and yields of financial assets. In turn, they hope to have an impact on households and businesses by lowering borrowing costs and encouraging an increase in spending to boost GDP.

However, there is a growing worry that these actions can’t solve the underlying problem and that the returns on these actions are diminishing fast. Against this backdrop, fiscal authorities are warning that they see central bankers and the decisions that emerge from their closed meetings as going “deeper and deeper into fiscal-type waters,” jeopardizing central bank independence. As John Cochrane has noted, “central banking really is the last refuge of central planners, which should embolden [us] to search for rules, institutions, and mechanisms to do a better job.”

The only solution now may be for a new accord between central banks and governments, an idea put forward by Professor Marvin Goodfriend of Carnegie Mellon. The premise is that the U.S. Congress has supported the Fed’s independence insofar as it has been a necessary precondition for the Fed to do an effective job. “Hence, the Fed should perform only those functions that must be carried out by an independent central bank,” writes Goodfriend.

The principles in the accord should acknowledge that purchases of long-duration bonds introduce interest rate risk and fair value losses. A commitment should be made that credit-related initiatives occur only with the permission of fiscal authorities.

The objective would be to get ahead of the political forces that are starting to circle central banks and the growing risk that indiscriminate constraints might soon be imposed on them.

What is not getting enough attention in these debates about new monetary intervention is that the very nature of central banking has dramatically changed in the post-crisis era. The pre-crisis central banks conducted monetary policy by open-market operations in short-term debt with no credit risk.

ECB President Mario Draghi is formulating a monetary backstop to tackle rising yields on government bonds driven by worries that certain European countries –Portugal, Ireland, Italy, Greece and Spain – will soon default. The idea is that by buying government bonds, these governments will be able to finance their deficits in the short to medium term.

The contours of the European debt crisis, and the future of the euro zone, are increasingly set by the ECB – a supposedly apolitical and technocratic institution. The ECB is using its new program as leverage to push unprecedented levels of policy changes against the democratic will of sovereign countries. Even aspects of sovereign domestic policy, such as banking regulation, are now under its purview.

The ECB has made the purchases conditional on other reforms to try and achieve a self-fulfilling sequence of monetary easing and fiscal consolidation. These “outright monetary transactions (OMT)” have shone perhaps the brightest light on the limits of monetary, rather than fiscal, policy.

These large-scale asset purchases leave the ECB in a position to take sizable losses in the case of a sovereign default, which may then require a central bank recapitalization (i.e., bailouts) from fiscal authorities in countries like Germany. Today, the ECB is effectively implementing fiscal policy by exposing itself to credit risk, which exists even if it pays too high a price for the sovereign bonds and a country does not default.

Like the ECB, the U.S. Federal Reserve now routinely engages in activities that are not clearly monetary in nature. Rather than funding other wayward governments, the Fed’s domestic actions look more like domestic credit policy, which is fiscal in nature.

The Fed’s new commitment to purchase more Fannie and Freddie MBS on an open-ended basis will leave it with an enormous balance sheet – approaching $3 trillion in assets today, from less than $1 trillion back in 2008. Though Fannie and Freddie are in conservatorship and backed by the federal government, Professor Goodfriend makes the point that only Congress possesses the power to designate a security as backed by the “full faith and credit” of  taxpayers.

Fed MBS purchases are akin to direct credit allocation in the economy, especially when compared with traditional monetary operations based on small holdings of short-duration Treasury debt. In his dissent against the recent Fed actions, Richmond Fed President Jeffrey Lacker said the MBS purchases “distort investment allocations and raise interest rates for other borrowers. Channeling the flow of credit to particular economic sectors is an inappropriate role for the Federal Reserve.”

With this recent action, the Fed will now be buying half of all newly issued mortgage-backed securities by Fannie and Freddie. In fiscal year 2011, the Fed also purchased 77 percent of all new Treasury debt that was issued.

These trends have sparked a growing chorus of economists warning that “by replacing large decentralized markets with centralized control by a few government officials, the Fed is distorting incentives and interfering with price discovery with unintended economic consequences.” These actions may also be “weakening the economy’s output by misallocating capital.”

If the Fed and ECB are not strictly monetary policymaking institutions, but rather technocratic bodies responsible for fine-tuning the economy, there are no limits to what they can be blamed for. Absent an accord, the market will only continue to take its cues from these central authorities – wondering whether they will intervene next in a different credit market, like student or automobile loans.

Ascribing every economic problem to the central banks pushes these institutions to fight battles they have no chance of winning. Moreover, any further economic destabilization that can be linked to their activism will only boomerang, as they get blamed for trying to solve problems that can and should only be handled by elected fiscal authorities.

Perhaps most important, striking a new accord now could relieve the Fed of the burden of trying to do what increasingly looks impossible: preserving its independence long enough so it can move responsibly when the time is right to raise interest rates and shrink its balance sheet, in spite of the views of elected officials.

As Phil Gramm and John Taylor commented recently: “[S]elling a trillion dollars of Treasury bonds on the market – at the same time the government is running trillion-dollar annual deficits – will drive up interest rates, crowd out private-sector borrowers and impede the recovery.” It’s not hard to predict what the chattering political class will be saying when the Fed faces these tough decisions.

Establishing an accord now wouldn’t involve the Fed wading into unchartered territory. There was the historic Treasury-Fed Accord in 1951 and a “joint-statement” between the two bodies in March of 2009. But the Fed’s recent actions call into question whether it still thinks “[g]overnment decisions to influence the allocation of credit are the province of the fiscal authorities.”

Striking a fresh accord now – before the Fed has to pursue its exit strategy – may be the only way to save the Fed from losing its independence at exactly the time it will need it most.

Arpit Gupta, a Ph.D. student in finance at Columbia University’s Graduate School of Business, contributed to this column.

PHOTO: U.S. Federal Reserve Chairman Ben Bernanke takes his seat to deliver remarks about a significant shift in the direction of U.S. monetary policy at the Federal Reserve in Washington September 13, 2012. REUTERS/Jonathan Ernst


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And how do American businesses react to the Fed’s Q1, Q2, Q3 and promises for unlimited money printing?
Just walk around in US cities, towns, and malls, and see if the number of vacant commercial properties has come down since 2009…
The business community (I.E. real world, not financiers) just scoffs at these Fed actions and promises, and hunkers down.
Perhaps they realize something that Wall Street doesn’t?

Posted by reality-again | Report as abusive

If you haven’t noticed, people started saving for a change and a bit less interested in borrowing and spending.

Is there a way the fed can lower the debt without involving public, instead of enticing the public to borrow and spend?

Posted by Mott | Report as abusive

Comparing the ECB and the Fed on equal terms is disingenuous because it is NOT a central bank — clearly, an “apples to oranges” comparison that make no sense.

Furthermore, the Fed CANNOT improve the US economy without comparable legislative action by Congress to support the Fed policy.

THAT is what is wrong, and why what Bernanke is doing will NEVER work, no matter how much money he prints.

The US economy is in a classic Keynesian “liquidity trap” and no amount of Fed intervention will help it to recover.

The real underlying problem, which you fail to disclose, is the massive job outsourcing that has been going on for decades, especially in the last 30+ years of free trade with China.

Congress MUST REVERSE the legislation enacted in that time period — specifically that dealing with trade and tax legislation that encourages the wealthy to make capital investments virtually anywhere in the world except in the US — or the US economy will NEVER recover, no matter how much faux money Bernanke pumps into the system.

This latest fiasco of targeting mortgage bonds is simply a massive transfer of debt from the already bankrupt Fannie Mae and Freddie Mac to the federal government debt.

It will NOT help the housing market to recover because there are NO JOBS.

Without jobs, there can be no housing recovery.

The Fed, especially the Bernanke Fed, is a “clear and present danger” to our economy.

Do whatever is necessary to shut him down, preferably before he does so much damage that we can never recover.

Posted by Gordon2352 | Report as abusive

By the way, I question the assumption being made that the central banks should be “independent”.


It literally gives the central bank the power of another branch of government, with no oversight whatsoever.

A central bank should be simply another government agency available to implement legislative decisions made by the “legimate” representatives of the people.

To do otherwise is to subvert the democratic process at a VERY dangerous point — its ability to affect the economy independently, and to wreak untold damage (for example, the Greenspan Fed
that allowed interest rates to decline to near zero for years for no reason at all, which resulted in one of the most massive speculative bubbles in history).

As I said above, do whatever is necessary to rein in this out of control Bernanke Fed before he manages to destroy our economy.

Posted by Gordon2352 | Report as abusive

Right, Fed inflationary policy has over decades had the effect of steadily reducing long term capital and increasing short term capital to the point where productive capital evaporates. The country as a result has been reduced to third world status, exporting raw materials and importing finished goods primarily from Asia where there is an abundance of plants and machinery to produce them. The country can no longer afford to build factories and machinery to produce goods as the required long-term capital is no longer available due to the inflationary policy.

Posted by amibovvered | Report as abusive