The Federal Reserve is an unelected board of bureaucratic experts that holds great sway over the US economy, the world economy, and the standard of living of the people of the United States.

Because of the arcane nature of its work, its responsibilities are not something we would want under the sway of political operatives.  The FED likes to say it is “independent” but history shows it often bends the political knee.  That is dilemma number one.  The FED is often not truly independent. Historians generally think FED Chair William Martin comes off fairly well versus Lyndon Johnson but Arthur Burns looks like he caved to Richard Nixon.  How Jerome Powell will turn out remains to be seen. Remember the President appoints people to the Federal Reserve Board and to head the FED. Is it likely they will appoint potential political adversaries or those more likely to be compliant?

Like all powerful bureaucracies, it must not only protect its institutional power (and by the nature of bureaucracy expand its powers), but it must also deal often with contradictory directives.  For example, Congress says the FED should  seek “full employment”, at the same time maintain “price stability.” Often, the two objectives come into conflict with each other.

The second dilemma is the FED is often wrong.  Not only has it made foolish statements and decisions quite recently such as “inflation is too low below 2%”, “inflation is too high at 9%”, “inflation is transitory”, “there will be multiple rate reductions”, and now today “maybe no rate reductions until next year”, but the FED has also presided over a catastrophic decline in the value of money.  Our current dollar is worth a tad more than 3 cents on the dollar of 1913, the year of the FED’s founding. As a maintainer of price stability, they are an abject failure. Meanwhile, financial panics and market crashes have become more frequent, and certainly more severe, since it and the political authorities have decided to interfere to  “fine tune” the business cycle.

This problem of being wrong gets deep into economic theory that we have little space to elucidate.  However, the FED has the challenge of any price-fixing scheme. Absent market forces that truly represent what supply and demand are in reality, a bureaucrat must pick a price he thinks the market will clear or sadly, a price that will elicit political support.  Either way, if the guess is too high, it creates a surplus of X because profits are excessive for those that produce X, and prices the buyers of X out of the market because the price is too high, thus crimping demand.  If the guess for X is too low, it creates a shortage of X because producers lose money and consumers binge because X is too cheap.

The FED is the chief price fixer of the most important signal in the economy, interest rates. Interest rates are the traffic signal for the deployment of capital. Quite recently, the FED had interest rates at nearly zero, off and on for almost 20 years.  This has never happened before in economic history. This has created a huge asset bubble and the worst inflation in 50 years.

The FED is also nominally in charge of the exchange rate of the dollar, which can influence world trade and commodity prices.

In this complex process, the current FED, staffed by university experts, has managed to lose about $160 billion dollars with a capital base of around $40 billion.  This is largely because the FED bought so many bonds to keep interest rates low. When they raised interest rates to fight inflation, it caused their bond portfolio to lose value. For an agency that supposedly wisely controls money, to owe so much more than you are worth is a remarkable accomplishment.

Of course, private holders of bonds have also lost corresponding billions, due to the FED action.

All that begs the question. How does the FED know what the exact money supply should be?  How does it know the right interest rate for any given time in history?  How does it know the right inflation rate? What is the “correct” level of employment? What is the correct dollar exchange rate? It can’t know all these critical economic determinants. It has all the problems of any price-fixing board that substitutes bureaucratic fiat for a genuine free market of supply and demand. And if they get any of it wrong, we are all screwed.

The institution was founded in 1913, in part because of the Panic of 1907, and the theory derived from that event and past panics that argued for a flexible or “elastic currency”.  The theory was the FED was to lend to good creditors when money was desperately needed, to avoid banking panics.  Later, the FED got integrated into the general body of Keynesian thought that the government and its agencies should act as a counterbalance to the business cycle.  When the economy is contracting, add money to relieve the severity of the downswing in economic activity, and reduce or remove money when the economy is overheating and creating inflation.  The levers are monetary policy with the FED and fiscal policy with Congress and the President.

That theory, while elegant in concept, has not operated very well because the FED cannot control the budget (fiscal policy as opposed to monetary policy).  Congress has decided to run deficits both large and small, regardless of the business cycle.  The Biden Administration as we have pointed out in the past has spent more money in inflation-adjusted terms, than that needed to fund World War I, World War II, and 30 years of deficit spending.  It did so with the economy recovering and not in recession.  As a result, the economy has overheated and gone into a debt binge at the national all the way down to the household level. Hence, where is the sense that the government is acting to counterbalance the swings in the business cycle?  Keynes’s idea falls flat as a pancake when it comes to actual implementation within a democratic political process. Who can you find in Congress who does not want to raid the public treasury to gain votes?

This creates third dilemma: the FED either faces down a wild spending Congress, or it becomes the facilitator of a wild spending, monetary alcoholic. It has become the latter.  It would be fair to say if the FED historically had kept its original charter for sound money and price stability, the Federal government could not have grown into the freedom-killing intrusive monster that it has become. It would not have had the money to do so.

It is through lavish Federal spending that we get situations like the Biden Administration forcing local schools to embrace the idiocies of the transgender lobby.  If schools don’t toe the line to this bureaucratic edict, the Federal government will cut off the funds local school districts have become addicted to. Or, to paraphrase the Supreme Court, that which the Federal government subsidizes, it should control.

One can’t blame the FED directly for such an abuse of democratic processes by centralizing it in the Federal administrative state, but the FED kept the heat off Congress for the consequences of its actions.  If Congress had to raise every dollar through taxes, or borrowing,  rather than having huge inflationary deficits to play with, the democratic feedback mechanism of voters howling to their Congressmen about taxes and high-interest rates, would have worked its magic. The FED, by printing money, and buying government bonds, has facilitated Congressional and Presidential spending excesses and the subsequent concentration of power in the Federal government.

This creates the fourth dilemma number for the FED. The politicians want inflation, and so does the public, sort of wants inflation.  We must credit James Grant, the financial columnist for this insight. Inflation can make its appearance in two forms.  One is asset price inflation, which rarely gets computed in the government CPI numbers.  For example, easy money and ultra-low interest rates create a flow of money that eventually finds assets.  This may “feel good” both to the public and politicians.  Who does not want their stock portfolio and 401k to go up sharply in price?  After you buy a home,  don’t you want the price to go up? It makes you feel smart and richer and now you have a rising asset you can borrow against (HELOCS and second mortgages) and deduct interest charges. You feel smarter and wealthier when your house and portfolio are rising sharply.

But then there is the other form of inflation that comes usually a little later after the asset boom.  That is consumer price inflation or what we have called “in-your-face inflation” where the cost of fuel, electricity, food, car payments, house payments, car insurance, and interest on credit cards; all start rising more sharply than wages.  The squeeze lowers the standard of living of people and this kind of inflation is anything but “feel good” inflation. Desperate households start to borrow heavily to stay afloat, setting the economy up for a deflationary crash.  This creates the kind of economic instability the FED was originally designed to moderate, but instead, the FED itself becomes the instrument of this excess.

How does the FED quell “feel good inflation” and “feel bad inflation” at the same time?  End one and you end the other. That is where the FED is right now. The steps necessary to stop the painful inflation will clobber the feel-good inflation because assets are highly leveraged with a lot of borrowed money.  This may explain why the severity of business cycle swings and financial panics have gotten worse and more frequent over the past decades.  The FED has hardly tamed the business cycle. Rather it has made them more ferocious.

Moreover, the FED has conveyed to markets it will rush to the rescue even during fairly modest contractions in the economy or bear markets in equities. By doing so repeatedly over the past 30 years or so,  it has created what insurance people call a moral hazard.  The prospect of having not to pay for reckless behavior makes the insured more reckless than before.  Why not, you will get a bailout.

A further complication is that when economic distortions are not corrected, they compound on top of each other. It is a little like the Forest Service rushing to put out every small fire that burns down old timber and underbrush. Soon the dry brush and old timber grow to such an extent the next lightning strike causes a fire so large it can’t be controlled.

Since Congress will not quit spending, the main tool the FED has is to raise interest rates. But that adds more pain on top of the inflation and runs the real risk of deflating the highly leveraged asset bubble that it has blown. This increases the risk of a serious recession, which will trigger, once again, another spending spree and rescue effort from Congress.

In short, the way the FED has morphed in its role over the years has brought it a long way from the argument that originally brought it into existence.

More tragically, its many dilemmas are now ours.

Photo by Paul Morigi