BOHANON & CUROTT: Fed’s growing power poses danger to financial markets

Economic Analysis by Cecil Bohanon & Nick CurottIt’s official: Traditional monetary policy is dead. The Federal Reserve’s giant footprint on financial markets is here to stay. Recently, Fed officials voted unanimously to put a pause on raising interest rates and, more importantly, to stop shedding unconventional assets, such as mortgage-backed securities, from its balance sheet.

Before the 2008 financial crisis, the Fed traditionally refrained from trying to influence long-term interest rates but merely provided the banking system with liquidity in times of crisis. Since 2008, the Fed has explicitly tried to steer the entire economy by targeting long-term rates. This is a major expansion of Fed power, cemented by the recent announcements.

This also illustrates an important lesson about the growth of government. During every war or economic crisis, government agencies grow and are delegated new powers. Afterward, the size of government decreases, but not back to the initial level, while most new powers remain.

Consider the Fed. During the recession it undertook the unprecedented actions of purchasing trillions of dollars of long-term government bonds and mortgage-backed securities. At the time, then-Chairman Ben Bernanke promised it was only a temporary emergency measure. Today, it is clear the Fed will roll off very few of these assets and will likely engage in new rounds of long-term asset purchases during the next recession. In other words, the Fed has ballooned and its new powers remain.

This is unfortunate. Traditional monetary policy had a long and successful track record. The unconventional new policy regime has harmed the economy in many ways. The Fed’s asset purchases have distorted the relative values of different financial assets, causing a misallocation of credit that has reduced economic growth.

In addition, suppressing long-term interest rates has incentivized private investors to switch from bonds to stocks in the search for higher yield. The resulting inflation of stock prices has benefited the rich more than the poor, increasing economic inequality.

It isn’t very surprising that the Fed is choosing not to reduce its own size or give up its new tools. How often does a government agency willingly vote to reduce its own powers? Of course, Fed officials claim they will only use these powers for the public good. But Fed bureaucrats are neither omniscient nor free from the disposition to engage in self-interested behavior. Fed officials often make mistakes. And now the rest of us are at the mercy of the Fed’s new central planning of financial markets.

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Bohanon and Curott are professors of economics at Ball State University. Send comments to [email protected]

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