The U.S. central banking system—the Federal Reserve, or the Fed—has come under heightened scrutiny in the wake of the 2007–2009 global financial crisis, even as its role in setting economic policy dramatically expanded. The Fed’s policy of maintaining low interest rates throughout the early 2000s, which resulted in cheaper mortgages, is cited by many economists as a major factor in the housing bubble, although some dispute this. Post-crisis, the Fed has faced scrutiny for its unprecedented large-scale intervention in the bond markets, including three rounds of so-called quantitative easing (QE) that helped sustain the recovery but transformed the Fed into an investment vehicle with an open-ended mandate to create money. As a result of QE, by March 2015 the Fed's total assets had surged to nearly $4.5 trillion, up from $869 billion in August 2007.
While partisan gridlock in Washington forced the Fed to take on a greater policy role in maintaining a fragile economic recovery, the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act expanded the central bank’s responsibility for evaluating the health of the nation’s financial system. By October 2014, rising U.S. growth rates and declining unemployment prompted the Fed to signal an end to its bond-buying program and an imminent return to a more normalized monetary policy.
The Fed's Dual Mandate
For most of the nineteenth century, the United States had no central bank to serve as a lender of last resort, leading to a series of crippling financial panics and banking runs. In response, Congress passed—and President Woodrow Wilson signed into law—the 1913 Federal Reserve Act. The law created the Federal Reserve System, comprising twelve public-private regional federal reserve banks.
Today, the Fed is tasked with managing U.S. monetary policy, regulating bank holding companies and other member banks, and monitoring systemic risk. The system’s seat of power is situated in the Washington, DC-based seven-member Board of Governors, currently headed by Fed Chair Janet Yellen. Each member is appointed by the president and subject to confirmation by the Senate. The members of the Board of Governors are part of a larger board, the Federal Open Market Committee (FOMC), which includes five of the twelve regional bank presidents on a rotating basis. The FOMC is responsible for setting interest rate targets and managing the money supply.
For most of the nineteenth century, the United States had no central bank to serve as a lender of last resort, leading to a series of crippling financial panics and banking runs.
Historically, the Fed's monetary policy has been governed by a dual mandate: first, to maintain stable prices, and second, to achieve full employment—the definition of which is debated by economists, but which is generally considered to mean an unemployment rate of 4-5 percent. (Unemployment lower than that is believed to spark a dangerous jump in inflation.) In pursuing these goals, the Fed has generally relied on interest rate policy, varying its federal funds target rate, the rate at which banks lend to each other, by altering its purchases and sales of U.S. Treasury bonds and other government securities.
The current benchmark by which many economists judge Fed policy is known as the Taylor rule, a formula developed by Stanford economist John Taylor in 1993, which stipulates that interest rates should be raised when inflation or employment rates are high and lowered under the opposite conditions. Taylor has argued (PDF) that the Fed’s loose monetary policy in the early 2000s likely exacerbated housing price inflation, thus spurring the subsequent collapse of the subprime mortgage market.
The Fed’s regulatory purview also steadily expanded through the 1990s. U.S. banking changed dramatically when the Gramm-Leach-Bliley Act of 1999 legalized the merger of securities, insurance, and banking institutions, allowing for the joining of retail and investment banking operations that had been separated under the 1933 Glass-Steagall Banking Act. The law also gave the Fed the authority to determine appropriate financial activities within bank holding companies and member banks. The Fed was now responsible for ensuring banks' soundness by enforcing provisions that included minimum capital requirements, banking consumer protections, antitrust laws, and anti-money laundering policies.
The Fed Chair
Few officials in Washington enjoy the power and autonomy of the Chair of the Federal Reserve. Analysts and investors hang on her every word, and markets instantly react to the faintest clues on interest rate policy. The unelected chair is not directly accountable to voters, and the Fed is largely free from the whims of Congress and is not subject to the appropriations process.
The Fed is effectively controlled by its chair, who acts as a spokesperson for the central bank, negotiates with the executive and Congress, and controls the agenda of the board and FOMC meetings. This level of power makes the appointment one of the president's most important decisions.
After former Chair Ben Bernanke announced his retirement in 2013, President Barack Obama was the first Democrat since 1979 to nominate the overseer of U.S. monetary policy. Obama chose Janet Yellen, a Yale-trained economist who entered public service in 1994, first as a Fed governor and then as chair of President Bill Clinton's Council of Economic Advisers, head of the San Francisco Fed, and vice-chair of the Fed Board of Governors. Yellen was confirmed by the Senate in January 2014, becoming the first woman to head the U.S. central bank.
Yellen was a strong voice at the Fed even before becoming Chair, issuing early warnings about the housing crash and pushing for more aggressive monetary policy to bring down unemployment. In her first year, as the United States saw a steady recovery in the labor market, Yellen moved to wrap up the QE program and began laying the groundwork for a rise in interest rates.
Dodd-Frank: A New Mandate
Excessive risk-taking by an undercapitalized banking system triggered the global financial crisis, and it became clear in the aftermath that a new set of regulations was necessary. The Dodd-Frank Act grew out of a need to "address this increasing propensity of the financial sector to put the entire system at risk and eventually to be bailed out at taxpayer expense," said a 2011 report by New York University's Stern School of Business.
Dodd-Frank instituted a third official mandate for the Fed, empowering it to regulate systemic risk and preserve financial stability. The Fed is now required to present its findings on risky, non-bank financial firms to the Financial Stability Oversight Council, which instructs the Fed on how to sanction those institutions.
Thanks to Dodd-Frank, the Fed is also now in charge of keeping a much closer eye on the solvency of major U.S. banking operations, via its supervision of "systematically important financial institutions." "The Fed has a great deal more responsibility," says Thomas Cooley, a professor at New York University's Stern School of Business and one of the editors of the 2011 report. "It is the primary watchdog for identifying systemically risky institutions of all types," he explains.
The Fed’s yearly Comprehensive Capital Analysis and Review (CCAR), launched in 2011, has become one of the most watched indicators of banks’ financial health. Through the CCAR, combined with the Dodd-Frank Act Stress Testing (DFAST), the Fed evaluates the risk exposure of the thirty-one largest financial institutions operating in the United States in order to determine whether their capital reserves would be sufficient in the case of another extreme economic downturn.
Dodd-Frank instituted a third official mandate for the Fed, empowering it to regulate systemic risk and preserve financial stability.
The post-crisis expansion of the Fed’s regulatory powers has led to a major consolidation of influence in Washington. Previously, the regional reserve banks, and the New York Fed in particular, took the lead in regulating the institutions under their jurisdiction. According to internal Fed strategy documents, however, the new oversight bodies—such as the Large Institution Supervision Coordinating Committee (LISCC), which implements the stress tests—centralize control of the regulatory process in Washington instead. This reorganization reflects the belief of some in Washington that the New York branch failed to properly oversee the major banks prior to the financial crisis.
Holes in the System: Origins of 'Systemic Risk'
Experts have sought to identify the key drivers of so-called "systemic risk," or the financial interdependencies that allowed a seemingly limited subprime mortgage crisis to culminate in widespread panic in the United States and abroad, as well as the failure of some of the country's most prominent financial institutions. Some critics of Fed policy partially blame the institution, especially its decision to keep the federal funds rate at 1 percent from 2003 to early 2005, which allowed for significant credit expansion.
In the 2009 book The Road Ahead for the Fed (PDF), Carnegie Mellon's Allan Meltzer wrote that, judging by Taylor rule guidelines (see graph below) on setting interest rates, former chair Alan Greenspan's Fed policy was too expansive, considering that short-term interest rates remained negative as the economy continued to grow. Greenspan attributed this policy to his belief that the U.S. economy faced a risk of deflation (a decline in prices due to a tightening supply of credit) similar to Japan's experience in the 1990s.
Does the Taylor Rule Still Apply?
Other experts point to the 1999 repeal of the Glass-Steagall Act, which led to an escalation in the number of non-bank institutions authorized to issue credit, as a catalyst for increased systemic risk. The share of credit extended by banks in the United States dropped from 60 percent half a century ago to 20 percent in 2009. Mauro Guillen, professor of management at University of Pennsylvania's Wharton School of Business, says the repeal of Glass-Steagall was part of a regulatory "race to the bottom" between the UK and the United States in the 1980s and 1990s as they competed to woo financial firms.
Former Fed Chair Ben Bernanke has also cited lax government regulation and gaps in oversight as causes of the crisis. In a March 2009 speech at the Council on Foreign Relations, Bernanke said, "The risk management systems of the private sector and government oversight of the financial sector in the United States and some other industrial countries failed to ensure that the inrush of capital was prudently invested, a failure that has led to a powerful reversal in investor sentiment and a seizing up of credit markets."
Now that the Fed has been charged with overseeing systemic risk, experts question how it can best respond to systemic threats while fulfilling its original dual mandate. Some argue that managing monetary policy and systemic risk presents the Fed with a conflict that could ultimately undermine price stability.
Professor Charles Calomiris of the Columbia University Graduate School of Business, for instance, argues that to successfully implement these varying objectives, monetary policy must be kept separate from macroprudential regulation, rules that govern how much risk banks can take on. Dodd-Frank, Calomiris says, does not do enough in this area. The law is "sympathetic" to the creation of a macroprudential authority, but "it doesn't provide any guidelines for what macroprudential regulation is," he says.
The End of Quantitative Easing
Some of the fiercest criticism of the Fed came after its November 2010 announcement that it would launch a second round of QE (known as QE2), buying $600 billion in long-term Treasury bonds to stimulate a still-struggling economy. Twenty-three economists wrote a letter to the Fed criticizing the plan for potentially stoking inflationary pressures, weakening the dollar, and failing to alter the jobless rate. QE2 wrapped up in June 2011. But following the S&P downgrade of U.S. debt in early August 2011, subsequent global market volatility, and fear of another recession, the Fed launched QE3 in September 2012, an open-ended program that lasted until October 2014.
"Monetary policy [alone] can't solve economic problems."—Thomas Cooley, New York University's Stern School of Business
The concept behind quantitative easing was to create more resources for the financial system, making banks freer to lend and the public more apt to borrow, says NYU's Cooley. Traditional tools used by the Fed to lower interest rates were ineffective when those rates already hovered around zero. But many economists argue that additional monetary easing doesn’t help if there isn't enough demand to borrow, and that fiscal policy is needed to boost investment in the real economy. The Fed should continue to hold interest rates down, Cooley says, but "monetary policy [alone] can't solve economic problems."
Still, such unconventional monetary policies were deemed "largely successful at achieving their domestic goals, and were especially effective at the time of greatest financial turmoil," according to an April 2013 report by the International Monetary Fund (PDF). Intervention stemmed the losses for volatile assets, such as mortgage securities, and provided maneuverability for central banks when they couldn't realistically enforce negative interest rates, the IMF report said. Moreover, the Fed's investment portfolio has returned more than $400 billion to the Treasury since 2010, although much of this was generated from the interest payments it received from the Treasury itself.
Despite the successes of quantitative easing, most economists and Fed officials agree that it can’t ultimately provide the fiscal or structural basis for macroeconomic stability. With U.S. growth rebounding and unemployment falling to 5.5 percent, the Fed has ended QE and moved to reduce its balance sheet to pre-recession levels. The next step is deciding when to begin raising interest rates back above their near-zero rate, a move that could come as early as June 2015.
This Congressional Research Service report examines the Federal Reserve's monetary policy in 2014.
This 2013 IMF report found that unconventional monetary policies largely achieved their domestic goals.
Bloomberg's "QuickTake" explains the Fed's taper and includes additional links tracing the biography of Fed Chair Janet Yellen.
This March 2015 address by Fed Chair Janet Yellen outlines her views on improving the oversight of large financial institutions.