The U.S. central banking system—the Federal Reserve, or the Fed—has come under heightened focus in the wake of the 2007–2009 global financial crisis, while its role in setting economic policy dramatically expanded. Post-crisis, the Fed faced scrutiny for its unorthodox monetary policy, known as quantitative easing (QE), which helped sustain the recovery but ballooned the Fed’s total assets from $869 billion in 2007 to nearly $4.5 trillion in 2017. At the same time, the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act [PDF] redefined the central bank’s responsibility for evaluating the health of the nation’s financial system.
Since 2015, the Fed has focused on returning to a more normalized monetary policy. Former Fed Chair Janet Yellen oversaw rising rates throughout 2016 and 2017 and announced the end of QE, a process known as tapering. President Donald J. Trump broke with precedent in 2018 by replacing Yellen with businessman and sitting Fed Governor Jerome Powell, the first non-economist to hold the post since the 1970s. Powell largely supported Yellen’s approach to unwinding the Fed’s unorthodox policies, but how he proceeds could have major implications for market stability.
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.
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 between 4 and 5 percent. The Fed has generally relied on interest rate policy to pursue these goals, 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. The chairman acts as a spokesperson for the central bank, negotiates with the executive and Congress, and controls the agenda of the board and FOMC meetings. Analysts and investors hang on the chair’s every word, and markets instantly react to the faintest clues on interest rate policy. The unelected chair, appointed by the president, is not directly accountable to voters, and the Fed is largely free from the whims of Congress.
After former Chairman 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 oversaw the first rise in interest rates in nearly a decade.
New presidents have almost always reappointed the sitting Fed chair to a second term regardless of party. But after Yellen’s first term expired in February 2018, Trump chose to replace her with Powell, a businessman, financier, and sitting Fed governor. During his 2016 campaign, Trump criticized Yellen for the Fed’s “easy money” policies, though observers say that Powell is likely to largely follow Yellen’s blueprint for slowly increasing interest rates. Powell, however, has been more skeptical about some of the Fed’s regulations, particularly on smaller banks that have faced more scrutiny in the wake of the financial crisis, and may be more willing than Yellen was to roll some of them back.
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.
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. 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.
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
One 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 bring down 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.
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]. 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, the Fed ended QE purchases in 2014. However, it did not move to start shrinking its $4.5 trillion balance sheet until October 2017, when Yellen announced the Fed would begin gradually reducing its bond holdings in monthly stages that will progressively increase through 2018.
While markets have continued rising in the face of the announcement, some analysts worry that the reversal of the Fed’s expansionary policy could cause a repeat of the 2013 “taper tantrum,” in which the Fed’s discussion of eventually reducing purchases led to prolonged market turbulence.
A Return to Interest Rate Normality
In addition to balance sheet tapering, the Fed began raising interest rates back above their near-zero rate starting in December 2015, when the bank unveiled a 0.25 percent rise in the baseline federal funds rate. In announcing the first rate increase since 2006, Yellen argued that the economic recovery had “clearly come a long way, although it is not yet complete,” and said that subsequent tightening would be “gradual.” The Fed waited a full year to raise rates for a second time, which it did in December 2016. In 2017 the pace of rate rises picked up, with increases in March and June, and another expected for December.
Some economists have lauded Yellen’s slow and steady pace, warning that returning to normalized monetary policy is like “defusing a bomb,” in the words of market analyst Kristina Hooper. Their worry is that while the Fed’s expansionary monetary policy boosted markets and encouraged borrowing, a rapid rise in interest rates could reverse that dynamic and potentially lead to another recession.
Other observers have raised concerns that the Fed’s prolonged low interest rates may have built up risks in the economy. CFR’s Sebastian Mallaby, author of an authoritative biography of former Fed Chair Alan Greenspan, believes that low rates may be encouraging financial bubbles like the ones that caused recessions in 2001 and 2007. Instead of predictability, he argues, financial markets could use more uncertainty from the Fed, in the form of faster-than-expected rate increases, to dissuade Wall Street firms from taking on ever more risk.