The Federal Reserve: From Central Bank to Central Planner
Momentous changes are under way in what central banks are and what they do. We are used to thinking that central banks' main task is to guide the economy by setting interest rates. Central banks' main tools used to be "open-market" operations, i.e. purchasing short-term Treasury debt, and short-term lending to banks.</br></br>Since the 2008 financial crisis, however, the Federal Reserve has intervened in a wide variety of markets, including commercial paper, mortgages and long-term Treasury debt. At the height of the crisis, the Fed lent directly to teetering nonbank institutions, such as insurance giant AIG, and participated in several shotgun marriages, most notably between Bank of America and Merrill Lynch.</br></br>These "nontraditional" interventions are not going away anytime soon. Many Fed officials, including Fed Chairman Ben Bernanke, see "credit constraints" and "segmented markets" throughout the economy, which the Fed's standard tools don't address. Moreover, interest rates near zero have rendered those tools nearly powerless, so the Fed will naturally search for bigger guns. In his speech Friday in Jackson Hole, Wyo., Mr. Bernanke made it clear that "we should not rule out the further use of such [nontraditional] policies if economic conditions warrant."</br></br>But the Fed has crossed a bright line. Open-market operations do not have direct fiscal consequences, or directly allocate credit. That was the price of the Fed's independence, allowing it to do one thing -- conduct monetary policy -- without short-term political pressure. But an agency that allocates credit to specific markets and institutions, or buys assets that expose taxpayers to risks, cannot stay independent of elected, and accountable, officials.</br></br>In addition, the Fed is now a gargantuan financial regulator. Its inspectors examine too-big-to-fail banks, come up with creative "stress tests" for them to pass, and haggle over thousands of pages of regulation. When we think of the Fed 10 years from now, on current trends, we're likely to think of it as financial czar first, with monetary policy the boring backwater.