The Federal Reserve – or the Fed for short – is again front and center in the news. With the economy improving and the stock market soaring, the Fed is likely to increase short-term interest rates several times in 2017.
Not everyone holds the Fed and its policies in high regard. Some say the Fed has been trying to do too much. Indeed, some even say the Fed’s policies have been harmful. Let me try to explain and then let you decide.
First, a little background. The Fed is one of the most powerful institutions in the country, especially on the economy. Created over a century ago as the “lender of last resort” to banks, the Fed’s original mandate was to prevent panic by depositors when widespread fears struck the economy. By keeping banks afloat during economic hard times, depositors wouldn’t withdraw their money and credit markets would continue functioning.
The Fed was active in pursuing this goal during the Great Recession. It provided money to financial institutions experiencing trouble, purchased loans directly and lowered the key short-term interest rate to zero percent. The purpose of the last policy was to motivate borrowing and spending.
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The economy did stop its free fall in mid-2009, and economic measures have been improving since then, though at a slow pace. Although the Fed was late to the game in perceiving the seriousness of the economic crisis, as were most economists, including yours truly, most professional evaluations say the Fed’s intervention was crucial to keeping a lid on the damage caused by the Great Recession.
So why has the Fed been under fire? While some question the need for a Fed at all – arguing private bank insurance could prevent massive withdrawals from banks during economic downturns – others support the Fed’s basic mission but say it has moved beyond that mission and is trying to micromanage the economy.
Specifically, critics point to two actions the Fed continued long after the immediate crisis of the Great Recession had passed. First, the Fed purchased financial assets well after the economy had moved into recovery phase. The Fed’s portfolio of financial investments now stands at $4.5 trillion, up from under $1 trillion before the Great Recession.
Critics argue it is not the job of the Fed to hold investments of this size. They also worry how the Fed could reduce its holdings without disrupting financial markets.
Critics have also questioned the Fed’s handling of short-term interest rates. While many could justify a zero-percent rate during and shortly after the Great Recession, the Fed kept the rate at zero percent until December 2015, more than six years after the economy resumed growing. Even today the rate is under 1 percent.
One obvious casualty of these low interest rates has been savers in low-risk investments, like U.S. government securities and bank certificate of deposits. With inflation still continuing, a zero or near-zero interest rate means savers are losing money in terms of purchasing power of their investments.
Another concern is that the super-low interest rates have motivated investors to pour money into the stock market and other higher-risk investments, perhaps ignoring the fundamentals behind those investments. The Dow Jones Industrial Average has risen more than 200 percent from its recent bottom in 2009. While some of this gain represents improved business conditions, part of the rise could represent a “sugar high” from the low interest rates.
The worry is what happens when interest rates return to some level of normalcy? Will the stock market drop? And what about the lost wealth of those savers who continued to invest in bank CDs and similar investments? Clearly their future financial goals, such as retirement, have been adversely affected.
In a way, the Fed can’t be blamed for its actions. In addition to the Fed’s original objective of supporting the financial system in times of crisis, Congress later mandated the Fed to pursue policies resulting in “maximum employment,” generally interpreted to mean a low unemployment rate. So the Fed can argue it kept its financial-asset buying program and low-interest-rate policy going until the unemployment rate reached “low” levels – generally thought to be in 4 to 5 percent. This didn’t happen until last year.
In my humble opinion, what this all means is that Congress needs to have a debate on what the guidelines should be for the Federal Reserve. Do we only want the Federal Reserve to intervene in the economy when the financial system is in trouble? Or do we also want the Fed to try “fine-tuning” the economy – that is, keeping the unemployment rate and the inflation rate within certain ranges?
The governing body of the Federal Reserve currently has three openings. President Trump has an opportunity to fill these positions with the confirmation of the Senate. The four-year term of Janet Yellen, the current chair of the Federal Reserve Board of Governors, expires at the end of January 2018. So if we’re going to have a debate about what the Fed should do, now is a great time.
It took our nation a long time to agree to establish a central bank like the Federal Reserve. This is understandable as the Fed has an enormous amount of power over our economy and daily lives. With controversy over the Fed’s policies since the Great Recession, maybe it’s a good time for you to help decide what the Fed should – and shouldn’t – be able to do.
Walden is a professor and Extension economist in the Department of Agricultural and Resource Economics at N.C. State University who teaches and writes on personal finance, economic outlook and public policy.