Published November 22, 2013
With a leadership vacuum consuming Washington since the financial crisis, one previously mystical institution has quickly morphed into the unofficial fourth branch of the U.S. government: the Federal Reserve.
The dramatic build-up of power and influence at the Fed has coincided with a lack of fiscal help from paralyzed Washington, dysfunction that pressed the central bank to deploy its limitless balance sheet.
For most of its 100-year history, the Fed has worked behind the scenes, goosing interest rates when needed, keeping an eye on inflation and acting as a lender of last resort to distressed banks. But that role has changed.
“The Fed is clearly getting more activist,” said Kristina Hooper, U.S. investment strategist at Allianz Global Investors.
The Fed held just $850 billion in assets on its balance sheet in July 2007, but that figure is set to swell north of $4 trillion by the time its bond-buying exercise is over. That represents about 25% of U.S. GDP, compared with just 7% during normal times.
“No one ever conceived of monetary policy having that kind of power,” said David Jones, a former Fed economist and author of Understanding Central Banking: The New Era of Activism. “The power of the Fed in influencing market conditions really has become the first line of defense against a financial crisis and the most important actor in trying to enact a recovery.”
And it’s not just a U.S.-centric story. Central bankers around the world are calling out plays from Ben Bernanke’s playbook for fourth-and-long situations (see: Bank of Japan).
'Adult in the Room'
In the U.S., the preferred method for treating the financial crisis would have been through strong fiscal policy enacted by Congress. But the deep budget deficit and its attendant political gridlock has rendered such a move impossible, leaving the Fed to fill the void.
While Fed policymakers may often disagree with each other, the central bank at least has a “majority that is acting and moving and actually doing things,” Hooper said.
That’s more than can be said for Congress, which remains deeply divided and seems unlikely to enact pro-growth policies such as an overhaul of the tax code any time soon.
“It seems like the Federal Reserve is the adult in the room. They are doing what they can to help the economy improve,” said Russell Price, senior economist at Ameriprise Financial (AMP).
The best example of the more activist Fed came in November 2008 when it took action despite exhausting its normal policy tool -- interest rate cuts -- by enacting quantitative easing. The unconventional bond-buying program was aimed at promoting growth by forcing rates lower.
“It was a necessary tool at that time to address the lack of liquidity in the market and the lack of confidence. We were on the precipice of something that could have gotten a lot worse,” said Hooper.
A Third Mandate?
The Fed enacted second and third iterations of QE as the economy threatened to fall back into recession and Washington remained on the sidelines.
More recently, in September, the Fed decided not to dial back QE -- much to the surprise of Wall Street -- due in part to concerns about the other branches of government. Alluding to the government shutdown and debt-ceiling debate, Bernanke cited “upcoming fiscal debates” that may produce “additional risks” to the economy.
Don’t expect this more activist Fed to shift course just because Bernanke is on his way out.
Janet Yellen, who won approval from a key Senate panel on Thursday to become the first female Fed chief, has advocated for aggressive action to fight unemployment. In addition to keeping prices stable and maximizing employment, Yellen and others have argued the Fed needs to do more to supervise the financial markets and find asset bubbles.
“That only serves to make the Fed more activist,” said Hooper.
Central Bank Activism Goes Global
Other central banks have followed in the Fed’s footsteps.
Back in 2009, the Bank of England launched its own bond-buying exercise to juice that country’s sluggish economy. The BoE is looking to gobble up assets worth 375 billion pounds ($605.8 billion) as part of that program.
Recently, the Bank of Japan announced plans to buy 60 trillion to 70 trillion yen a year ($596 billion to $695 billion) in an effort to fight deflation and daunting demographic hurdles.
Just this week reports emerged that the European Central Bank could enact a negative deposit rate to encourage lending.
“Much of the developed world is suffering from low growth and high debt. They are all being treated by the same doctor: their central bank. They are all getting the same medicine,” said Hooper.
“The idea we are being weaned off our medicine suggests we are nearing outpatient status. Europe has a much worse situation -- they are in serious condition, maybe even intensive care. Japan is in the emergency room,” she said.
Jeffrey Shafer, who served on the Fed staff in the 1970s, noted this isn’t the first time that conditions on the ground forced the central bank to become more activist.
“(The Fed) was rather cautious and slow under Arthur Burns to respond to inflationary pressures (in the 1970s). One could say it wasn’t very activist. And then inflation got out of hand and Paul Volcker came in and brought in an activism that took one’s breath away,” he said.
Still, the expanded power of the current Fed is much more striking when compared with its more conservative role in conventional times. In the past, the central bank had been more focused on preventing inflation than promoting growth or searching for bubbles.
“We really have a much more powerful institution…than we ever had before,” said Jones.
It’s too early to say whether or not the Fed as the fourth branch of the government is a good thing or bad.
Supporters make a strong case that the emboldened Fed fought off a near-death experience in 2008 and 2009.
But the fear is that now that the economy is stronger an over-reliance on monetary policy will take pressure off of fiscal policymakers to settle their differences, while at the same time create asset bubbles down the line.
“Do we become so dependent on central bank welfare that we’re not capable of handling the next crisis?” Hooper asked.