Before new trillion-dollar federal spending bonanzas became a regular occurrence, the Federal Reserve’s announcement that it lost over $700 billion might have garnered a few headlines. Yet the loss met with silence. Few Americans have noticed the huge increase in both the scale and the scope of the central bank or the dangers that it poses to the American economy. As Fed-driven inflation becomes the Number One political issue in America, that will change.
The Fed’s losses owe to a shift in the way it does business. Before the 2008 financial meltdown, the central bank tried to control interest rates by buying and selling U.S. bonds. A few billion in purchases or sales could move the whole economy, and this meant that the Fed, which operates much like a normal bank, could keep a relatively small balance sheet of under $1 trillion.
Since the financial crisis, the Federal Reserve, like other developed-world central banks, has used a different playbook. It provides enough funds to satiate the entire banking world, and it seeks to adjust the economy by paying banks more or less interest to hold those funds. These payments keep private-sector interest rates from dropping too low. When it first undertook this “floor” experiment, the Fed’s balance sheet exploded to more than $4 trillion. After the Covid pandemic, it approached $9 trillion.
A larger balance sheet means greater risks. And the Fed has added to that risk by purchasing longer-duration assets. Pre–financial crisis, the Fed bought mainly short-term federal debt. Only about 10 percent of all the U.S. bonds owned by the central bank lasted longer than ten years. Now, that figure has risen to 25 percent.
It is essential that we stick to our statutory goals and authorities, and that we resist the temptation to broaden our scope to address other important social issues of the day.4 Taking on new goals, however worthy, without a clear statutory mandate would undermine the case for our independence.
In the area of bank regulation, too, the Fed has a degree of independence, as do the other federal bank regulators. Independence in this area helps ensure that the public can be confident that our supervisory decisions are not influenced by political considerations.5 Today, some analysts ask whether incorporating into bank supervision the perceived risks associated with climate change is appropriate, wise, and consistent with our existing mandates.
Addressing climate change seems likely to require policies that would have significant distributional and other effects on companies, industries, regions, and nations. Decisions about policies to directly address climate change should be made by the elected branches of government and thus reflect the public’s will as expressed through elections.
At the same time, in my view, the Fed does have narrow, but important, responsibilities regarding climate-related financial risks. These responsibilities are tightly linked to our responsibilities for bank supervision.6 The public reasonably expects supervisors to require that banks understand, and appropriately manage, their material risks, including the financial risks of climate change.
Central Bank Independence: “Price stability is the bedrock of a healthy economy and provides the public with immeasurable benefits over time. But restoring price stability when inflation is high can require measures that are not popular in the short term as we raise interest rates to slow the economy. The absence of direct political control over our decisions allows us to take these necessary measures without considering short-term political factors.”
New Goals: “Taking on new goals, however worthy, without a clear statutory mandate would undermine the case for our independence.”
Stick to Mandates: “It is essential that we stick to our statutory goals and authorities, and that we resist the temptation to broaden our scope to address other important social issues of the day.”
Climate Change: “Without explicit congressional legislation, it would be inappropriate for us to use our monetary policy or supervisory tools to promote a greener economy or to achieve other climate-based goals. We are not, and will not be, a ‘climate policymaker.‘”
Inflation finally slowed to a near halt in November, possibly signaling a winding down of the prices crisis that has gripped American households this year.
Prices rose just 0.1 percent on average during November, the Department of Labor reported on Tuesday morning. The year-over-year inflation rate fell as well, to 7.1 percent for the 12 months ending in November. That’s the lowest annualized rate since December 2021, and is significantly lower than the 7.8 percent annualized rate reported a month ago.
This also marks the fifth consecutive month in which the annualized inflation rate has held steady or fallen, after peaking in July at an astounding 9.0 percent.
That trend suggests that the Federal Reserve has finally gotten a collar on rising prices. The central bank’s board is expected to hike interest rates for the seventh time this year when it meets on Wednesday. That means it will continue getting more expensive to obtain a mortgage or a car loan, and credit card interest rates will continue to rise—but also that savings accounts and other interest-based investment vehicles are paying larger returns.
The U.S. Federal Reserve announced a new rate increase of half a percentage point Wednesday in its ongoing effort to curb inflation.
The Fed raised the rate by 50 basis points, as expected, the seventh rate hike this year. This increase is smaller than the four previous 75 basis point increases but is still a notable increase, putting the range at 4.25%-4.5%.
“Recent indicators point to modest growth in spending and production. Job gains have been robust in recent months, and the unemployment rate has remained low,” the Fed said. “Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher food and energy prices, and broader price pressures.”
The Fed blamed the Russian war in Ukraine for the price hikes. That war delayed the supply chain and increased costs, but the price increases began long before that war, due in part to trillions of dollars in federal debt spending since the pandemic began.
Reduced liquidity for bonds is getting to be a problem, according to Treasury Secretary Janet Yellen.
At a speech before the Securities Industry and Financial Markets Association annual meeting Tuesday, she reiterated an earlier observation that diminished ability to sell bonds is worrisome. Still, at SIFMA, she sought to temper her concern by adding that traders aren’t facing snags executing orders, with the biggest negative impact of lessened liquidity confined to higher transaction costs.
The gauge for bond volatility, the Merrill Lynch Option Volatility Estimate, aka MOVE index, has jumped some 40% since mid-August. Other than a spike in March 2020 at the onset of the pandemic, the index (it launched in 2019) has been fairly placid—until 2022 and the beginning of big rate hikes. This all is reminiscent of the stock market’s fast-paced volatility lately.
Another related difficulty for bonds: the imbroglio resulting from the Federal Reserve’s interest rate increases and the resulting strong dollar risk worldwide. That has promoted a rush by other central banks to match the Fed and jack up rates. To Richard Farr, chief market strategist at Merion Capital, one risk of this trend is that Treasury bonds will end up hurt.
Debate now rages about whether the Federal Reserve should continue to raise interest rates to tame inflation or slow down these hikes and see what happens. This is not the first debate we’ve had recently about inflation and Fed actions. The lesson we should learn, and I fear we won’t, is that government officials and those advising them from inside or outside the government don’t know as much as they claim to about the interventions they design to control the economy.
As a reminder, in 2021, the dominant voices including Fed Chairman Jerome Powell asserted that the emerging inflation would be “transitory” and disappear when pandemic-induced supply constraints dissolve. That was wrong. When this fact became obvious, the messaging shifted: Fed officials could and would fight inflation in a timely manner by raising rates to the exact level needed to avoid recession and higher unemployment. Never mind that the whole point of raising interest rates is precisely to soak money out of the economy by slowing demand, which often causes unemployment to rise.
Over at Discourse magazine, my colleague Thomas Hoenig—a former president of the Fed’s Kansas City branch—explains how Fed officials faced similar pressures during the late 1960s and 1970s. Unfortunately, he writes, “Bowing to congressional and White House pressure, [Fed officials] held interest rates at an artificially low level….What followed was a persistent period of steadily higher inflation, from 4.5% in 1971 to 14% by 1980. Only then did the [Federal Reserve Open Market Committee], under the leadership of Paul Volcker, fully address inflation.”
Often overlooked is Volcker’s accomplishment: the willingness to stay the course despite a painful recession. Indeed, it took about three years from when he pushed interest rates up to about 20 percent in 1979 for the rate of inflation to fall to a manageable level. As such, Hoenig urges the Fed to stay strong today. He writes, “Interest rates must rise; the economy must slow, and unemployment must increase to regain control of inflation and return it to the Fed’s 2% target.” There is a cost in doing this; a soft landing was never in the cards.
American politicians had tried to control inflation before. The presidents and power brokers of the 1970s had tried price controls, public campaigns, pressure programs, blame games, and attempts to redefine basic economic terminology. The parties differed on the specifics, but both seemed to agree that the voting public and the private sector were to blame, not the bureaucrats and politicians in charge.
Inflation, in short, was a political problem, in the sense that it caused problems for politicians. But it wasn’t one America’s politicians knew how to solve.
On the contrary, America’s political class had spent the ’70s failing to fix inflation, or actively making it worse, often with policies designed to address other political and economic problems. That decade’s price hikes were prolonged and exacerbated by political decisions born of short-term thinking, outright cowardice, and technocratic hubris about policy makers’ ability to enact sweeping changes and manage the macroeconomy.
To understand how interest rates influence inflation, we need to understand how inflation works. Inflation is the result of too much money chasing too few goods. Over the last several months, this has occurred amid a surge in demand and supply chain disruptions worsened by Russia’s invasion of Ukraine.
In an effort to combat inflation, central banks will raise their policy rate. This is the rate they charge commercial banks for loans or pay commercial banks for deposits. Commercial banks pass on a portion of these higher rates to their customers, which reduces the purchasing power of businesses and consumers. For example, it becomes more expensive to borrow money for a house or car.
Ultimately, interest rate hikes act to slow spending and encourage saving. This motivates companies to increase prices at a slower rate, or lower prices, to stimulate demand.
Ark Invest founder and CEO Cathie Wood is drawing snarky comments on and off Twitter after posting an open letter to the Federal Reserve challenging the central bank’s aggressive interest-rate hikes.
Wood published the letter on her firm’s website Monday as her ARK Innovation ETF (ARKK) sustained more blows in a year that has seen its returns slide more than 60%. Bloomberg reported Tuesday that the fund, which has fallen more than double the S&P 500′s decline, was down about 11% over three days.
Wood voiced concern the Fed is making a policy error that will lead to deflation and said it seemed to be basing its decisions on two lagging indicators: employment and headline inflation from official reports such as the Consumer Price Index. These variables “have been sending conflicting signals and should be calling into question the Fed’s unanimous call for higher interest rates,” she wrote.