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Original text was published by Becente in WSJ and International Economy, titled the Federal Reserve’s new “functional gain” monetary policy
There are abridgements here that when lab-created labs escape their limitations, they can wreak havoc in the real world.Once released, it cannot be easily put back into the control area.The “extraordinary” monetary policy tools released after the 2008 financial crisis also changed the policy system of the US Federal Reserve system, with unpredictable consequences.The Fed’s new operating model is actually an experiment in functional gain-based monetary policy.
When its traditional tool—the overnight rate—is at the lower limit of zero interest rates, the Fed uses large-scale asset purchases as a monetary policy tool.This has caused serious distortions in the marketand with unexpected consequences.Moreover, this also disrupts the Fed’s unique independent role in the American political system.The independence of central banks is the basis for the success of the U.S. economy.
The Fed must change course.Its standard monetary policy toolbox has become too complex and difficult to manage, its theoretical basis is uncertain, and economic consequences are also problematic.Functional gain-based monetary policy must beSimple, measurable policy tools replaceto achieve a narrow mission.This approach is the clearest and most effective way to provide better economic outcomes and protect the independence of central banks in the long run.
Unconventional currency experiments, not policies
After the 2008 financial crisis, the Fed was understandably determined to help revive the U.S. economy.It has just successfully modernized its traditional responsibilities as a lender of last resort and helped stabilize the financial system.As Walter Bagehot described in Lombard Street (1873), this role is a tried-and-tested function of the central bank in managing liquidity crises.Although the complexity of modern credit markets makes project design innovative, the principles guiding Fed intervention have long been established.
Inspired by the success of responding to the financial crisis, the Fed began to gain greater confidence in its ability to guide the economy.The growing sense of frustration strengthens this confidence.The slogan “The central bank is the only savior” has gained widespread recognition among policy makers.
Against this backdrop, the Fed expanded its liquidity tool to unknown areas, reusing asset purchase plans as tools for stimulating monetary policy.This experiment overlooks the fact that even short-term interest rate changes—a relatively mature and well-understood tool—the impact is often unpredictable.
When evaluating monetary policy transmission, the challenge is even greater when it comes to unconventional policy tools such as large-scale asset purchases (also known as quantitative easing, QE).These tools are designed to stimulate the economy through various channels, but none is fully understood.In theory, lower long-term interest rates would encourage corporate investment and borrowing for other productive activities, thereby increasing real economic output.Higher asset prices driven by lower interest rates are expected to have a “wealth effect” as newly affluent consumers increase spending, thereby boosting economic growth.In addition, reducing the supply of government securities in the market is intended to drive investors to move towards riskier investments, thereby stimulating greater economic activity through the so-called “portfolio balance” channel.
However, the Fed’s accuracy in measuring the impact of these tools remains extremely limited.Monetary economists try to quantify the impact of unconventional monetary policy with equivalent short-term interest rates.According to a leading model, Wu-Xia Shadow Fed Funds Rate, the unconventional tool adopted by the Federal Reserve in the 2010s had pushed the effective nominal interest rate to -3% by May 2014.Despite such low nominal interest rates, the U.S. economy has never experienced the nominal GDP growth that such a position should have brought.
Other studies have reached different conclusions.A 2017 paper by the Bank for International Settlements found that quantitative easing had little impact on actual output.However, the statistically significant impact on stock prices is more than ten times its impact on actual output.However, then-Federal Chairman Ben Bernanke had no doubts about the effectiveness of unconventional monetary policy, famously stated in 2014:“The problem with quantitative easing is that it works in practice, but it doesn’t work in theory.”
The Fed’s confidence in its powerful new tools is like a central planner assured its people that their grand power and foresight will bring about an unstoppable prosperity.But despite Bernanke’s insistence, the mystery of expected and unexpected effects of quantitative easing remains.
Unpredictable consequences in the real world
One might think that all these new tools and the centralization of U.S. financial markets on the Constitutional Avenue will give the Federal Open Market Committee (FOMC) a clearer perspective on economic direction.At the very least, all of these “functional gains” should allow FOMCs to guide the economy more effectively to the path they expect.But that didn’t happen because the Fed simply didn’t understand how the new functional gain-based monetary policy works.
In its November 2009 Economic Forecast Summary, the Federal Reserve predicts real GDP will grow by 3% in 2010 and accelerate to 4% in 2011, hoping that its new “functional gain” monetary tools and large-scale fiscal deficits will stimulate the real economy.Real growth in 2010 was close to forecast at 2.8%, but growth did not accelerate, but slowed to 1.6% in 2011.At the end of 2010, FOMC still forecast annual growth rates of 4% in 2012 and 2013.In fact, the growth in 2012 was only 2.3% and 2.1% in 2013..
During the first six years of this system,The Fed’s one-year forecast error for real GDP averages 0.6 percentage points — a considerable mistake when the target is usually around 2%.——And the biennial forecast error is larger on average, at 1.2 percentage points.Total view,The Fed’s biennial forward forecast overestimates real GDP by 7.6%, and the forecasted economy is more than $1 trillion larger than the actual results (in 2009 USD).These repeated mistakes show that the Fed is overly convinced of its own capabilities and the role of expansionary fiscal policy in stimulating growth.
Things changed when the Trump administration turned fiscal policy toward tax cuts and deregulation to strengthen the supply side of the economy.The Fed’s one-year growth forecast has been low in the first three years of the epidemic (2017-2019) when the administration was in power (2017-2019)..However, optimism about fiscal stimulus has resurfaced after President Biden was elected.The most obvious example is the assertion of the $2.1 trillion USD 2021 Rescue PlanInflation triggered will be “temporary”.Some price pressures did prove temporary, but FOMC eventually had to tighten much more than it expected.
At the end of 2021 — despite clear signs of accelerated inflation — the Federal Reserve predicts the federal funds rate to be 0.9% by the end of 2022, 1.6% in 2023 and 2.1% in 2024.Even in June 2022, when inflation broke out in full swing, the Fed still predicted a peak interest rate of 3.8% at the end of 2023, which would then fall.In fact, the interest rate has remained above 4% since December 2022.
The Fed’s failure to foresee inflation surge stems from its flawed model.The direct application of the supply and demand principle has been issued an alarm.Many observers at the time pointed out that the scale of fiscal stimulus was much larger than the estimated output gap.However, the Fed — breaking its politically neutral tradition — openly calls for stimulus and then cooperates with ultra-loose monetary policy.
The Fed’s wrong economic model also relies on a fundamentally wrong and self-reinforced assumption: inflation is mainly determined by inflation expectations, which are affected by the Fed’s own communication and credibility.In other words, the Fed believes that just showing its commitment to low inflation is enough to maintain price stability.Mervyn King, former President of the Bank of England, aptly described this approach as the “Knut theory” of inflation, likening it to the medieval king who was believed to command tides.As Governor Kim said, “A satisfactory theory of inflation cannot be the form of ‘inflation will remain low, just because we say it will’.”
There is no political bias in the economic model.But they are based on certain beliefs about how the economy works, which may in turn be related to various political views.FOMC has been overestimating its ability to stimulate real growth and control inflation.It overestimates the effectiveness of expenditure-based fiscal policies, and underestimates the effectiveness of tax cuts and deregulation.All in all, its model has the same biases as the political tendencies that have plagued much of Washington for decades: We know better than the market.
In addition to mistakenly relying on flawed models, the Fed’s unconventional monetary tools also undermine an important source of feedback: financial markets.The liquidity wall created by quantitative easing flattens the cost of capital in various industries and sectors, and actually floods the market’s ability to send out early warning signals when the real economy shows signs of weakness or inflation rises.Under normal circumstances, financial markets could have served as a barometer of potential risks to the economic outlook.However, the distortion caused by the Fed’s actions prevented these signals from appearing in time.
Side note: Fed’s policy—”Socialism for investors, capitalism for everyone else”
Unconventional monetary policy does have important supporters.But these sources of support raise important questions about the properness of these policies.The pillars of academic economics – Ben Bernanke and Janet Yellen – pioneered the expansion of the Fed’s toolbox in the 2010s.It’s no surprise that academic economists are one of the strongest supporters of the Fed’s expanded role.
Financial markets are another major advocate of unconventional monetary policy.This is not surprising, as the Fed’s monetary innovation is designed to play a role by boosting the asset market.As the Fed lowers interest rates, the prices of fixed-income tools have risen mechanically, while other assets have been raised as the Fed deliberately pushes investors to take higher risks.Although there is little evidence that this policy has led to an increase in real economic output, it clearly creates an important support base for unconventional monetary policy in the financial markets,Financial markets are highly sensitive to the existence of the Fed put, because the Fed repeatedly conducts financial rescue.This has contributed to the increase in long-only investment strategies, mainly low-cost index funds and private equity, thus weakening the potential of capital markets to play a disciplined role through price discovery.
It is worth noting that critics of the Fed’s unconventional tools appear at both ends of the economics field, suggesting a convergence among a small number of people—who possess the expertise needed to understand the effects of quantitative easing regardless of political inclination, and are not captured by the hierarchy or market incentives of academic economics.
Progressive financial policy expert Karen Petrou, in her book “The Engine of Inequality: The Fed and the Future of American Wealth” (2021), documented how the Fed pursued the “wealth effect” to stimulate the economy backfired.”Unprecedented inequality clearly proves that the wealth effect is very effective for the rich, but it is an accelerator of economic hardship for others.” Economists’ attention to the so-called benefits of the wealth effect is particularly strange, because the Fed’s asset purchases have a stronger role in the discount rate of asset valuation than on the cash flow that supports asset prices.Asset owners are unlikely to spend in advance due to changes in discount rates, and are more likely to spend in advance due to increased revenue.And even if they do increase consumption, this effect may reverse once the discount rate is normalized..
In Petru’s view, the intensification of income and wealth inequality is a function of U.S. asset allocation—a Fed should have regarded it as a given fact.Only the richest individuals have the financial assets that are most directly affected by the Fed’s large-scale asset purchases.Looking further down, a considerable number of middle-class people in income distribution have net worth of housing, but this asset is less sensitive to Fed’s financial market manipulation..However, 50% of the bottom of the income distribution has little net wealth, “from cars primarily, not other durable or financial assets that can preserve or add value.” As a result, the natural consequence of the Fed’s pursuit of wealth effects is actually increasing the wealth of the luckiest members of our society.
Furthermore, Petru noted that the Fed is accustomed to saving financial asset owners, which actually corrodes the disciplinary role that financial markets should play in the economy.Due to the continuous intervention of the Federal Reserve, Petru noted that a prominent investor wrote: “Financial markets have expected the Fed to intervene in any sharp decline in stock prices.” Another commentator wrote that this situation actually created a situation of “investor socialism, capitalism for everyone else”.
Reporter Christopher Leonard, in his book The King of Cheap Currencies: How the Fed Destroys the American Economy (2022), details the rich history of the people and conferences that drive the expansion of the Fed’s toolbox.He specifically documented former Kansas City Fed Chairman Thomas Hoenig famously objected in 2010, opposing the Fed’s decision to start a formal asset purchase program that is not aimed at financial stability but rather as a monetary policy tool that later became known as quantitative easing (QE).Honig historically avoided partisanship—he was elected vice-chairman of the Federal Deposit Insurance Company (FDIC) to fill a Republican seat and was officially nominated by President Obama—and was considered a “hawkish” among monetary policy practitioners.
However, Honig’s visionary objection to quantitative easing is not about the threat of inflation, but about theWhat he calls the “allocative effect” of policies.For Honig, “The Fed’s policies have far more than just impacting overall economic growth. The Fed’s policies have transferred funds between the rich and the poor, and they encourage or suppress things like Wall Street speculation that could lead to devastating financial collapse.” Honig’s warning came true in the next decade, with financial assets soaring without flowing into the real economy.
Honig’s career also highlights his commitment to solid long-term economic thinking, which sometimes conflicts with the short-term urgency of driving quantitative easing decisions.In his 1991 interview with then-Fed Chairman Alan Greenspan for the Kansas City Fed, Honig believed that “monetary policy needs restraint and a long-term vision…because every action you take has long-term consequences.” Apparently Greenspan agreed at the time because he then approved Honig’s hiring.But under the urgency of short-term economic pressure, Greenspan forgot this information, leading Honig to oppose a decision in 2001 to cut interest rates again at the end of the 2001 easing cycle, because Honig believes that the FOMC should spend more time evaluating the effectiveness of its previous actions before further cuts.Subsequently, the asset bubble triggered by the Fed’s loose monetary policy in the early 2000s helped the accumulation of risks in the financial system, and ultimately led to the 2008 financial crisis.
For decision makers, the pressure to be seen as “doing something” can become omniscient, leading to decisions like initiating quantitative easing.Fed Chairman Bernanke used this reason to defend quantitative easing on the FOMC.”It’s very, very difficult…we don’t have good choices. It feels safer to do nothing, but on the other hand, our economy is doing very badly…so there’s no safe choice.” Foreseeable that Bernanke named his 2015 memoir The Courage to Act, and he undoubtedly hopes to be considered a great pioneer in pushing the borders, rather than a prudent caregiver who modestly carries out his limited mission.
Monetary infectious diseases invade the real economy
Although the Fed has limited understanding of the relationship between functional gain monetary policy and real economic output, one result is clear: it has serious distributional consequences in American society.These consequences became apparent for the first time during the 2008 financial crisis.According to Bai Zhihao’s classic model, central banks should make emergency loans at punitive rates in this case to ensure liquidity operations do not mask deeper solvency problems and prevent fraud.
However, the Fed’s continuous intervention during and after the financial crisis,Creates a de facto guarantee for asset owners.This leads to a harmful cycle, where the state’s wealth controls by asset owners is growing.Within the class of bourgeois owners,The Fed actually chose winners and losers by expanding its asset purchase program from Treasury bonds to private debt, with the real estate industry receiving special favorable treatment.
The impact of these policies goes far beyond asset owners who directly benefit from quantitative easing.In the corporate sector,The Fed’s intervention provides a clear advantage for large companies, which is often at the expense of smaller companies.Large companies that can enter the debt capital market can take advantage of historic low interest rates to fix their debts to long-term fixed rates.In contrast, small companies that tend to rely on floating-rate bank loans found themselves squeezed by rising borrowing costs when the Fed was forced to raise interest rates in 2022.
What is even more destructive is the distribution effect of functional gain monetary policy on households, which has strained the social structure of the United States.The Fed’s operations along risk and time curves compress interest rates and push up asset prices.This mechanism disproportionately benefits those who already own assets.For example,Homeowners see their property’s value soaring.Given the structure of the U.S. housing market, over 90% of mortgages are fixed-rate, and they are essentially immune to rising interest rates.As a result, even if interest rates rise, the real estate market is still overheated, with more than 70% of existing mortgage rates above three percentage points lower than the current market rate..
at the same time,Less wealthy families who are excluded from the home buying market by high interest rates have missed the appreciation of assets that benefit wealthy families.As interest rates push up borrowing costs, these families are also facing tighter financial conditions.Meanwhile, inflation—somewho was driven by the Fed’s massive expansion of its monetary base through quantitative easing and its related coordination on record fiscal spending—disproportionately affects low-income Americans, further exacerbating economic inequality.This also prevents a generation of young Americans from owning their own housing.The Fed allows class and generational gaps to worsen due to failure to achieve its inflation mission.
Unconventional monetary policy threatens political health
The Fed’s growing footprint has also had a profound impact on the political economy, putting its precious independence into a precarious situation.By extending its terms of reference to areas traditionally reserved for the fiscal authorities, the Fed blurs the line between monetary and fiscal policy.This is particularly evident in the Fed’s balance sheet policies, which affect credit allocations throughout the economy.When the Fed buys non-federal government debt, it directly affects which sectors acquire capital, thus intervening in areas that should belong to the capital market and fiscal authorities.
In addition, the Fed’s entry into the Treasury market has brought it into the field of public debt management, a role traditionally supervised by the Treasury Department.This entanglement between the Federal Reserve and the Treasury is worrying because it creates an impression,Right nowMonetary policy is used to accommodate fiscal demand rather than deployed solely to maintain price stability and promote maximization of employment.
The Fed’s expanded toolbox also has broader consequences for the actions of elected officials.The Fed’s action cultivates a culture among the old establishment in Washington, encouraging dependence on central banks to pay for bad fiscal policy.Rather than taking responsibility for fiscal decision-making, past administrations and congresses expected the Fed to intervene when its policies resulted in economic dysfunction.The dynamic “central banks are the only savior” creates undue incentives for fiscal irresponsibility, as the cost of poor governance is increasingly delayed or overshadowed by the Federal Reserve’s monetary intervention.
At the heart of these concerns is the erosion of central bank independence, a cornerstone of sustainable economic growth and stability.As the Fed expands its quota, it erodes the traditional boundaries that keep it safe from political influence.Critics who believe the Fed is overreaching power by engaging in fiscal or quasi-fiscal activities are correct.
The Fed’s mistakes and arrogance in decision-making puts its credibility at risk and endangers its independence in its core responsibilities in monetary policy.Overestimating the power of oneself or one’s own institutions is a fundamental human trait.In some cases, it can even be beneficial.But this is very problematic for the implementation of monetary policy.The Fed claims it needs independence.But is it really independent?Or is it captured by its past ghosts and its own conceit?Monetary policy fueled the real estate bubble, while the Fed and other institutions’ slow perception of warning signals exacerbated financial collapse.Despite its faults, the Fed gained more power after the financial crisis than before it.Unfortunately, these expanded power and lack of humility will only further increase the Fed’s mistakes.
Over-regulation, conflict of interest and threat of independence
Reforms after the Congressional crisis have greatly expanded the regulatory footprint of the Federal Reserve system.The Dodd-Frank Act of 2010 places bank holding companies with assets of more than $50 billion (later changed to $100 billion, as the case may be) under Fed supervision, authorizing them to designate and regulate systemically important non-bank institutions, mandate annual stress tests and living will reviews, and make them the primary supervisor of key clearing houses and payment systems.The abolition of the Savings Agency’s Supervisory Agency also incorporates the regulation of its holding companies into the Federal Reserve.Coupled with the Basel III capital and liquidity rules formulated by the Federal Reserve itself,These changes transform central banks from lenders of last resort to micro-prudential regulators dominant in U.S. financial industry.
Fifteen years have passed and the results are disappointing.The 2023 Silicon Valley Bank, Signature Bank and First Republic Bank collapses all occur at companies under Fed inspections and customized stress tests.Regulators marked vulnerability but failed to report; those same employees who wrote monetary policy briefsMissed the most basic duration risk.Earlier scandals—from Wells Fargo’s misuse of sales to JPMorgan’s “London Whale”—also worsened under the Federal Reserve’s regulation.
The core issue is structural: the Fed now regulates, lends to the banks it supervises, and sets profit calculation methods for these banks.This is an inevitable conflict that blurs accountability and endangers the independence of monetary policy.
This conflict in turn affects policy.A Fed, worried about exposing its own regulatory failure, has a direct motivation to keep liquidity abundant and interest rates low to avoid falling asset value and banks in trouble.on the contrary,A positive anti-inflation stance forces the Fed to acknowledge those failures as austerity policies reveal a fragile balance sheet.Either way, monetary policy becomes a prisoner of self-interest in regulation.
A more coherent framework will restore the specialization of the institution.The Federal Deposit Insurance Corporation (FDIC) and the Office of the Supervisor of the Currency (OCC) have decades of expertise in auditor-led, rule-based banking supervision.The powers of daily safety and prudential inspections, consumer protection enforcement, and immediate corrective measures should be attributed to these institutions, allowing the Fed to focus on the traditional tasks of macro-prudential supervision, lender liquidity, and monetary policy.Re-empowering the FDIC and OCC will strengthen accountability, rebuild a firewall between regulation and monetary policy, and help ensure the independence of the Federal Reserve while improving bank security.
The Fed’s nonpartisan status becomes suspicious
The Fed must also address its increasingly partisan impression in recent years.The Manhattan Institute’s research reveals a disturbing shift in the political composition of the Reserve Bank’s directors.Between 2010 and 2015, the proportion of Reserve Bank directors who made political donations was roughly balanced between the two parties, with about 20% donating to the Republican Party and 20% donating to the Democratic Party.However,Since 2015, the percentage of donations to Republican directors has dropped to 5%, while the percentage of donations to Democrats has risen to 35%..This shift has sparked concerns that the Fed is becoming a partisan, undermining neutrality and independence.What makes this problem more complicated is thatThe Fed’s strategic engagement with the media, including offering discounted access based on the tone and content of the report.By leveraging the media as a tool to advance its interests, the Fed has created the impression that it is trying to evade goodwill supervision.This behavior weakens its accountability and further erodes trust in the agency.
Regulation and monetary policy are best left to a politically independent institution.But the agency must also be responsible.Mature and responsible individuals are first responsible for themselves.Of course, this is a challenge because we all have pride.For an institution, self-accountability should be easier because it is theoretically without psychology and conceit.But the self-interest of the institution plays the same role.At the Fed, the evidence is clear, especially after it adopts functional gain-based monetary policy.The Fed has become bound by its institutions’ own interests at the expense of national interests.It does not objectively evaluate its performance and adjust its processes accordingly.
The Fed continues to evade accountability because any criticism of its performance will attract the media’s voice, saying that legitimate criticism is an attack on the independence of the central bank.The Fed should be able to enforce its policies without political pressure.Monetary policy should not be formulated at the White House or Capitol Hill.But when the Federal Reserve’s monetary policy produces suboptimal results, pointing out the Fed’s shortcomings becomes the obligation of our country’s elected leaders.
in conclusion
The severe intervention of the Federal Reserve system in recent decades in financial markets has led to a series of unexpected consequences.Although these unconventional tools were introduced to respond to special circumstances, their effectiveness in stimulating economic activity remains unclear.But they obviously have serious distributional consequences in American society, hurting the Fed’s credibility and threatening its independence.
The core of the Fed’s independence lies in its credibility and political legitimacy.Both pillars are jeopardized by the Fed’s decision to extend its role beyond its traditional mission and engage in activities equivalent to functional gain-based monetary policy.These actions erode the institution’s isolation layer from political pressure, endangering its ability to operate as an independent entity.
Going forward, the Fed must commit to reducing its distorted impact on the market.At the very least, this may include the Fed’s use and subsequently stopping unconventional policies like quantitative easing only in a real emergency and in coordination with the rest of the government.This may also require an honest, independent and nonpartisan review of the entire agency and all its activities, including monetary policy, regulatory policy, communication, staffing and research.We now face not only short-term and medium-term economic challenges, but also the dire long-term consequences that a central bank that puts its own independence at risk.To ensure its future and stability of the U.S. economy, the Fed must reestablish its credibility as an independent institution, focusing only on its maximization of employment, stabilization of prices andThe legal mission of moderate and moderate long-term interest rates.
