The US central bank must evaluate its impacts on financial markets and the real economy.
Global marketplace digitalisation has caused expeditious financial innovation and the Federal Reserve lags behind the curve battling a regulatory wall. Once overcome, central bankers face the dilemma of reigning in innovation, protecting consumers but dampening the recovery or fuelling asset price bubbles. The reinvention of the Fed must occur in conjunction with market innovation to avoid credibility loss and monetary debasement.
The Fed has a unique relationship with the government in its long-term struggle to retain independence and control regarding financial stability. It works in alliance with the Financial Stability Oversight Council (FSOC) and supervises 10,000 banks and credit unions. However, its interconnectedness with the government causes slow progress on financial stability issues.
Slow to the mark
In the early 2000s, banks with overarching directives to remain competitive expanded clientele demographics to vulnerable subprime borrowers. Securitisation became popular, portfolios of asset- and mortgage-backed securities were tranched and sold to the wider public as investment-grade products. Moreover, after the majority of trading pits closed in the 1990s, electronic markets quickened the growth of financial derivatives, synthetic collateralised debt obligations and credit default swaps used for speculative purposes ballooned the insurance market capitalisation. Concurrently, central bank assumptions, definitions and models mildly changed. If the central bank was flexible, actively searching for potential threat, to restore information failures, its balance sheet would appear $4.5tn more attractive today. However, even if the Fed had realised its downfalls sooner, it did not have the human or capital resource capacity to respond immediately.
Since the Great Financial Crisis, the Fed has continued responding inflexibly. The financial stability framework has only changed minorly since the 2010 Dodd-Frank Act despite rapid technological advancements. The ultra-low federal funds rate has reduced the profitability in traditional services, thus banks have lowered operational costs through intensifying capital expenditure, for example the global AI financial technology market's 2025 expected valuation is $22.6bn. Furthermore, fintech has reduced entry barriers to establishing levered funds and has facilitated wider market access. If interest rates remain unchanged, the development pace of new, unregulated, financial products will quicken and the Fed will make similar mistakes.
Caught off guard
Despite the expectation of the Fed's dovish sentiment to gradually reverse, winding down the $120bn monthly security purchases, the Fed surprised the market by predicting two 0.25% federal funds rate hikes to 0.6% by 2023 end in the June 2021 dot plot projections. Over half the most dovish Fed members in March likely shifted their outlook to more hawkish; 2021, 2022 and long-term forecast were unchanged. However, Powell reiterated his criticism of the dot plot, citing the uncertainty forecasting medium-term market conditions.
Large changes in projections with little extra data from March 2021 has multiple interpretations that tarnish credibility. Firstly, the FOMC realised original inflationary forecasts of non-transitory factors were underestimated; core PCE Inflation is over 50% above target. Secondly, given Powell insisted no change from the transitory inflation outlook, Fed Governors may not possess the necessary psychological strength to ride out the temporary inflation spike now it has materialised and is taking a path above initial projections. After all, it is ordinary human behaviour to readjust biases too much once initial forecasts are proved wrong. In addition, the central bank cannot demonise inflation to achieve full employment in low-skill sectors and ethnic minorities, the latest ending unemployment spells.
However as previously stated, the Fed has to contend with their dual mandate: price stability and maximum employment and please the market. Iterating stern forward guidance to calm overextended equities whilst the labour market further recovers does seem an appropriate policy. On the contrary, rising bond yields and declining real wage growth strain bank lending and stagnates job matching - illustrating the connection between financial markets and the real economy.
As policy pivots, heads of regional US central banks act as market puppets. For example, following the June meeting Bullard and Kashkari provided contradictory advice - the former suggesting a necessary rate rise by 2023 and the latter opposing rate increase till at least 2024. Governors can gauge the extent to which the market has priced in the new policy, these messages also act as frontrunners for additional hawkish messages. Bullard and Kashkari have voting rights in 2022 and 2023 respectively. Rogue central bankers weaken the Fed's credibility but illustrate there are healthy levels of contention inside FOMC meetings.
Future threats and reinvention
The Fed cannot reinvent itself because it is too intertwined with the US Treasury. In the 2010 Dodd-Frank Act, the government equipped the central bank with greater powers to regulate systemically important financial institutions (e.g. stress tests). However, the oversight of financial stability threats remains mostly under the Treasury with the Fed still acting as its slave. Meanwhile, the UK's independent financial regulator, the Financial Conduct Authority (FCA), can make decisions purely in the interest of maintaining financial stability and protecting consumer's hard-earned savings without additional political incentives.
Crypto-wallet accessibility has increased, exposing market participants to highly volatile products. In particular more vulnerable retail investors; patterns repeat. In January 2021, the FCA banned the UK use of crypto-derivatives after prohibiting their retail use in October 2020; with no government influence the Authority took early decisive action. The Fed must decide whether cryptocurrency growth, a market capitalisation worth over $2tn in April 2021, is a threat to financial stability. Cryptocurrency professionals with rigour, transparency and no conflict of interest are most capable to regulate the industry; meanwhile, the FSOC are slow to understand new products. Financial stability regulation must be independent, risk-specific divisions created and employees promoted to higher pay packages - lowering opportunity cost - who have greater insight into future financial stability risks.
Short business cycles accompanied by large exogenous shocks (e.g. biohazard, nuclear, climate and cyber threats) will cause unmanageable debt levels. As fiscal debt piles higher the percentage of the debt which the Fed absorbs is crucial, the Fed's balance sheet has doubled to $8tn from pre-pandemic levels. Moreover, the Fed is facing a multifaceted liquidity trap; the federal funds rate and the countercyclical capital buffer rate (CCyB) are close to and at zero respectively. Therefore, when crises materialise the Fed has no additional firepower except quantitative easing which will eventually destabilise the fiat system, fails to stimulate growth and exacerbates wealth inequality. With interest rate slack banks can survive without huge government support. High US base capital requirements (capital conservation buffers, supplemental leverage ratios, and bank surcharges) has meant no need for the CCyB, the CCyB should be raised when bank confidence and lending rises.
Although persistently high inflation is undoubtedly bad for economic growth and valuations, average inflation targeting is an effective policy as it allows a higher mean inflation rate over the medium-term so debt holdings undergo financial suppression faster. However, two per cent inflation targetting will not solve the liquidity trap issue and long-run trends will continue to erode monetary policy's ability to stimulate an economy. The Fed must aim to generate attractive interest rates to return savings to natural levels, creating a virtuous cycle of investment and growth even in the US' matured economy.
In essence, if inflation targeting is a sustainable policy, the current target is too low. Raising the inflation target allows central banks to leverage interest rates more successfully in more frequently occurring crises. Secondly, the independence of the central bank is crucial, using professionals to assess future risks early will mitigate future costs of inaction. Through communicating their long term goals to reverse the federal funds rate trend, using policies that promote inflation as a growth by-product and quickly dealing with financial stability issues will restore the Fed's credibility and market control in all stages of the business cycle, at least for a little longer.
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