BankThink

After recent failures it's clear: Fed must be restructured

The recent failing performance of the Federal Reserve System suggests it needs to be restructured to focus more effectively on its monetary mission of stable prices and maximum employment.

The Fed has been cited for many failures in recent times, including the 1970s' Great Inflation, the Subprime Crisis and the Great Recession. The Fed’s repeated characterization of inflation last year as “transitory” was one of its biggest mistakes, and one with which we are still living.

Federal Reserve Exterior As Fed Keeps September Rate Hike In Focus Amid Strong Economy 
Andrew Harrer/Bloomberg

The Fed compounded this transitory mistake this year by signaling specific interest rate increases, but reversed its decision at the last minute by apparently leaking it to The Wall Street Journal. It lost much of its remaining credibility not only among central banks but also the American public, facing the highest inflation in 40 years plus a likely recession.

The Fed’s poor performance is best summarized by a quote from the Nobel laureate Milton Friedman: “There is no institution in the United States that has such a high public standing and such a poor record of performance.”

I would respectfully add “There is no institution with such a huge and effectively unregulated budget and such a poor record of performance.”  Fed budgetary data show total expenses of $6.4 billion in 2020, with three-fourths from its 12 Federal Reserve banks.

Having studied the Fed for over 50 years and taught my Wharton students about it for over 40 of those years, I believe there are at least four reasons for its poor performance.

First, it has become increasingly political, as first documented by the analysis of former Fed Chair Alan Greenspan’s calendar dating to 1996. That and the subsequent analysis of Ben Bernanke’s calendar concluded they were the two of the three most political Fed chairs in recent times. Calendars of Fed chairs and other top officials are now public without requiring painstaking FOIAs.

The current Fed chair, Jerome Powell, after many very public disagreements with former President Donald Trump, understandably wanted to keep his job under President Biden. In my opinion, he obligingly kept rates at record lows last year despite unprecedented fiscal stimulus and money supply growth. This dreadfully dovish policy further overheated the stock market and economy, but he was reappointed. It is my further opinion that Fed chairs, often  considered the second most powerful people in Washington, will do what they can, like most politicians, to maintain personal power, even at the expense of the dollar’s purchasing power.

Second, this Death of Fed Independence resulted in considerable “mission creep” causing it to lose focus on its main job. It was recently criticized for research on “social policy topics” like climate change and social justice, reflecting political and normative views of unelected officials in what is supposed to be an independent agency.  

This is evident in its recent 700-page proposal to reform the Community Reinvestment Act, which it cleverly clothed as an “interagency” effort. As a result of this mission creep, where the Fed is run more like a university with 12 Federal Reserve bank campuses, the agency has become an economic jack-of-all-trades but unfortunately a master of none.

Third, the Fed strategically uses its supposed independence to help justify the lack of real budget and performance accountability. What company would keep researchers, including over 400 Ph.D. economists, when their best prediction last year was transitory inflation?  And, who can justify two of the 12 Federal Reserve banks in Missouri, other than the fact that it was our nation’s geographic and railway center when the Fed was established in 1913?

Fed congressional oversight is an oxymoron, as a review of their hearings show few overseers who truly understand monetary policy. Most economists realize there is no upside criticizing the Fed, especially those wanting research grants, invitations to exclusive conferences, or other perks doled out by the Fed board and FRBs. Minimal accountability begets minimal performance.                    

Fourth, the Fed board and FRB presidents, through no fault of their own, have become media celebrities, with every word uttered in speeches or CNBC interviews being dissected by Fed watchers. This celebrity status began with Alan Greenspan and his equally popular wife, the NBC anchor Andrea Mitchell, once named Washington’s No. 2 Power Couple.

This celebrity status somehow morphed into their being thought of as economic geniuses when, like most “dismal scientists,” they far too often pull the wrong economic levers behind the Fed curtain. Mistakes can simply be blamed on factors beyond their control. Very few chairs have apologized for the Fed’s dismal performance, and those who have are guilty of some of the biggest monetary mistakes.

Considering the Fed’s too often politically inspired performance, I have long proposed the board of governors be relocated to New York City. Many other countries avoid locating their central banks in their political capital to help preserve independence.

My other Fed structural reform would be to halve the number of FRBs to just Atlanta, Chicago, Dallas, Kansas City, New York and San Francisco. All Fed conferences should be held at these FRBs instead of pricey resorts like Jackson Hole.

Instead of taking Professor Friedman’s extreme recommendation of abolishing the Fed and replacing it with a strict monetary rule, it should follow more flexible and transparent alternatives like the Taylor Rule that would have clearly required anti-inflationary actions last year. FOMC meetings should be public to shine some light on the secrecy that reduces individual accountability and fuels market uncertainty.

Regarding mission creep, the Fed should eliminate all research and budgets unrelated to its monetary mission. To start with, the Fed’s bank and holding company regulatory and supervisory role (and that of the FDIC and OCC) should be placed into a new independent federal bank regulator to avoid the current “competition in laxity.”

Speaking of independent federal agencies, all compliance and consumer protection responsibilities of the Fed (and that of the FDIC and OCC) should be transferred to the CFPB to again eliminate regulatory shopping. This would have avoided the recent regulatory infighting over CRA reform.

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