The growing clout of central banks
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