Books

Here's What Everyone Needs to Know about the Federal Reserve

Author Stephen H. Axilrod explains the three major changes in store for the Federal Reserve.

The following is an excerpt from the new book The Federal Reserve: What Everyone Needs to Knowby Stephen H. Axilrod (Oxford University Press 2013): 

What major challenges face the Fed as an organization in the future?

Judged from today’s conditions, I would mention three. First, the Fed needs somehow to bring regulatory issues more to the fore in considering its monetary policy. It seems to be working in that direction. That will be greatly helped when the president actually nominates a governor to become vice chairman for supervision, the position added in the DFA. As earlier noted, the position has not yet been filled—left vacant since President Obama signed the DFA that created it into law in July 2010, about two and a half years ago from the time of this writing. While a governor can be designated by the chairman of the Board to perform the tasks, the position will evoke more authority and raise the profile of regulation within the Fed when held by a person who is sustained and perhaps even galvanized by the approval of both the President and the Senate for that particular task. Nonetheless, the Fed’s role and flexibility in better combining regulatory issues and monetary decisions will remain complicated by the wide dispersion of regulatory authority in the country—not to mention the long process still ahead for fully implementing the diverse provisions of the DFA, with the inevitable jockeying for bureaucratic authority and power that entails.

Fortunately, regulatory conditions and the overall stability of financial markets are likely to be seriously at cross-purposes with monetary policy rather infrequently. But when that hap- pens, markets can then be subject to disruptions and crises so far beyond the norm that they are politically and socially destabilizing for the country. Against that background, the challenge for the Fed is to assure itself more regularly and more intensely than has been its wont in the past about the stability of the macro-financial system.

That could well require, among other things, something like a regular Fed assessment of the macro-financial system similar to its regular semiannual report on macro-economic developments and monetary policy required by the Congress (in addition to its newly required biennial report on its own supervisory activities).

Second, it behooves the Fed to continue with its efforts to regain the institutional credibility with the public and the Congress that was severely shaken by the credit crisis. It had been thrown into so much doubt that even the Fed’s viabil- ity as an independent institution or, perhaps more practically, as an institution that could pursue its independent powers as effectively as desired seemed in question.

Some progress has been made to date I believe, but the institution’s credibility will again be tested once the eco- nomic after-effects attributable purely to the psychological damage from the crisis are behind us (they probably are by now). The FOMC will then have to begin making the very difficult decisions and choices implicit in its dual mandate for monetary policy. For instance, how much inflation will the nation need or tolerate for a potential economic recovery to be strong enough to revive the country’s sense of well-being? Or, if recovery falters much longer, how much more willing would the Fed and its principal officials feel about speaking even more plainly about the limits of monetary policy com- pared with other governmental policies in face of economic weakness?

If, or to be more historically accurate, when the economy once again becomes more cyclically volatile, the substance of the Fed’s more open communication policies—in general a plus to its credibility—might be in need of fine-tuning. There seems no doubt that the prompt announcements about the specifics of current policy have been and will remain impor- tant for policy implementation and credibility. But only time will tell whether indications of future policy intent and the quarterly forecasts of key economic developments will need further tinkering, in one way or another, if they are to help bolster the Fed’s reputation over the long run. However that may be, the Fed’s institutional stature will depend, as usual, almost wholly on how the economy performs and on how well inflation is contained.

Nonetheless, since economic volatility will remain a fact of life the Fed’s stature will also depend in some degree on how the public judges whether it is performing as well as it can in the face of all the economic, political, social, and worldwide cir- cumstances that are well beyond its control. That impression will depend importantly on the ability of its chairman, the only official of the Fed who can authoritatively represent the institu- tion, to communicate with the public and markets in a way that appears both empathetic and convincing. It may also depend on the Fed’s ability to manage itself (and the president to use his appointive powers) to ensure that the institution is broadly governed and run consistent with the need to bring sound judgment from all walks of life into the sophisticated economic but also very practical issues it necessarily deals with.

To be convincing, a chairman’s views need to be expressed with a popular touch that does not turn off the 99.7% or so of the people who find economics to be arcane and even some- thing of a “dismal science”—a label often and rather unfairly attached to the field. Obviously, that is a combination of vir- tues not easy to find in one person, whether trained as an economist, as have been four of the past five chairmen of the postwar period, or not.

Third, though less pressing a challenge than the previous two, would be an effort to intensify thinking about structural and operational adaptations as the startling, technologically driven innovations of recent decades continue. The structure of the Federal Reserve System itself might appear increasingly outdated, as economies and financial markets of regions of the country become more and more interdependent and the oper- ational role of regional banks appears less crucial.

However, it is very doubtful that the useful role of regional banks in carrying out payments, examinations, and lending functions, as well as giving the Fed and its national monetary policy a more human local presence, would ever fade away. Still, there are likely to be further changes in the distribution of economic and financial activity that could, at some point as technology bounds further and unpredictably forward, raise political questions about the distribution, number, and size of regional banks. Many of the underlying issues are already being taken into account, it would seem, as the Fed does its own administrative restructuring to keep in step with, if not in the forefront of, the radical changes in financial technol- ogy affecting the private markets with which it is inextricably interlinked. It would seem that more is in store, somewhere down the line.

How well has the Fed served the country?

This author’s opinion is “fairly well.” The inflation of the 1970s in the United States was on the moderate side of what was happening in many other developed countries at a time when inflation and inflation expectations were becoming some- thing of a worldwide phenomenon, intensified by the oil price shocks of the period.

And the great credit crisis with its associated deep reces- sion in the second decade of the new century—a major and virtually unprecedented challenge for the Fed—has come to seem less unique in view of unfolding events in Europe and elsewhere. It is not too much of a stretch to find that some- thing like a “buy and borrow now and worry later” syndrome infecting the culture of the period has afflicted other areas of the world as well.

The Fed, while not without a responsibility for the onset and depth of the crisis, has handled the recovery process as well as could be reasonably expected. It has done what it could. It has filled up the punch bowl just about to overflowing, but the party has so far been very quiet.

When it livens up, the Fed will have to begin the task of emptying the bowl. It will be a big task. Fortunately, the Fed’s policy instruments are traditionally more effective on the restrictive than the expansive side. During the recovery from the crisis, more help from an expansionary fiscal policy would have made the party better. But the timing of fiscal policy, and the political and social factors influencing it, is another and rather sad story.

As to the Fed and monetary policy, looking back over the past 60 years or so, there is no doubt that mistakes were made. The inflation of the 1970s could have been more strongly resisted. In recent years, the stock market and housing bubbles might well have been pricked before they got so far out of hand. Still, in the end, the Fed successfully did what central banks were invented to do. It was quite responsive to its counter-cyclical obligations, it brought inflation under control, and it reliqui- fied and helped regenerate a collapsing credit market.

Reprinted fromThe Federal Reserve: What Everyone Needs to Knowby Stephen H. Axilrod with permission from Oxford University Press, Inc.  Copyright © Oxford University Press 2013.

Stephen H. Axilrod is the author of The Federal Reserve: What Everyone Needs to Know. (Oxford University Press, 2013)