By Christopher Bremer, Director, Private Client Services Portfolio Management
Northwestern Mutual Wealth Management Company
Come January, a nasty confluence of events could send the U.S. economy right back into a recession, fresh off the November elections. So says Federal Reserve Board Chairman Ben Bernanke, who fears economic regression if politicians don’t quickly address the U.S. budget deficit along with expiration of the Bush-era tax cuts and extended unemployment benefits. This trifecta of potential problems could place the winner of the November elections in a predicament, particularly if there’s a division in control of the presidency and Congress.
Bernanke’s concern about the state of the economy hasn’t changed: he believes that tepid growth in employment, coupled with fiscal problems at home and abroad, suggest another recession is more likely than not. And should the problems in the eurozone escalate and Greece exit, the odds of a recession will increase. If a recession does occur, the Fed’s resources would be insufficient to avert it, he declares.
“If no action is taken by the fiscal authorities, the size of the fiscal cliff is so large that there is absolutely no chance that the Federal Reserve would have any ability whatsoever to offset that effect on the economy,” Bernanke said in a speech in late February. Recent economic data affirms Bernanke’s views that while the economy is muddling along, it isn’t growing robustly and could slip into a recession if any of several conditions manifest themselves, including a tax increase, expiration of extended unemployment benefits or agreed-upon budget cuts.
Growing employment – and by extension, the overall U.S. economy – is just one of the many jobs of the Federal Reserve. It is also tasked with maintaining price stability, regulating the financial system, preserving the stability of the financial system and acting as a banking system lender.
Following the 2008-2009 financial crisis, the Dodd-Frank Act greatly expanded the Fed’s powers. In this month’s commentary, we’ll examine the origins of the Fed, how its role has evolved, the limits of its power to influence the U.S. economy and what the Fed is likely to do to affect the economy during the next several years.
Throughout the 19th century and into the early 20th century, financial panics, recessions and depressions occurred regularly. Because there was no central financial coordinating body, banks frequently failed. When banks failed, depositors lost their savings and the entire financial system was disrupted. Congress created the Federal Reserve on Dec. 23, 1913 in an effort to place the country’s financial system on a more secure footing.
The Fed is a somewhat curious amalgam of the public and private sectors. At the top of the Fed’s organizational structure is the seven-member Federal Reserve Board of Governors who are appointed by the president and confirmed by the Senate. The Fed is made up of 12 Federal Reserve Banks headquartered in cities throughout the country. These banks are owned by the commercial banks in their districts in that the banks hold stock in them; however, they are tasked with serving public goals and are overseen by the Fed Board of Governors.
The Federal Reserve Open Market Committee (FOMC) is perhaps the most visible face of the Fed due to its role in setting interest rates, through which it controls monetary policy. The FOMC sets interest rates through the control of the Federal Funds rate, which is the interest rate banks charge for interbank overnight loans (fig. 1). While all 19 members of the Fed Board of Governors and the presidents of all the Regional Banks sit on the FOMC, not all of the Regional Bank presidents have voting rights.
As a private and public entity, the Fed’s structure has been subject to criticism. Analyzing the organization’s structure, there are some potential conflicts of interest in that private bankers are involved in their own regulatory body. In May, a storm of controversy erupted when JPMorganChase lost as much as $5 billion in a trading snafu. The fact that company chairman Jaime Dimon is a Class A Director of the New York Fed at a time when his company is under investigation by regulators doesn’t look good. In fact, Treasury Secretary Timothy Geithner suggested in an interview with PBS News Hour that it might make sense for Dimon to resign.
While the Fed’s role in setting interest rates and monetary policy has always brought it a certain amount of public scrutiny, the evolution and expansion of the Fed’s role following the financial crisis has, in some quarters, put the equivalent of a target on its back. During the financial crisis, the Fed, in conjunction with the Treasury Department, rapidly expanded its balance sheet by lending money to member banks in order to avert a collapse of the international financial system (fig. 2).
In addition, the passage of the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act bestowed new powers on the Fed to break up so-called “Too Big to Fail” financial institutions while at the same time subjecting the Fed to Congressional audits and transferring some of its consumer protection authority to the newly created Consumer Financial Protection Agency. Because of the lack of ongoing fiscal stimulus, the Fed has attempted to stimulate the U.S. economy by enacting two rounds of quantitative easing. Known as QE1 and QE2, these actions involved buying U.S. Treasury bonds to bring down and keep down longer-term interest rates in order to spur business and consumer lending.
A group of congressmen led by Texas Representative Ron Paul (R - Texas) has vocally criticized the Fed for interfering in the U.S. economy. And Alan Greenspan, the previous chairman of the Board of Governors, has been attacked for his long-term low interest rate policy, which many believe fueled the housing bubble that led to the financial crisis.
The Fed has multiple roles as a regulator. It monitors bank holding companies, state-chartered banks that are members of the Fed system and certain international banking operations. The Fed supervises, inspects, monitors and examines bank operations to assess their condition, financial stability and compliance with banking regulations. The Fed also supervises the activities of foreign banks that operate in the U.S.
The Fed maintains authority over electronic funds transfers and the responsibilities and rights of businesses and consumers who make use of this electronic financial activity. It also polices the Community Reinvestment Act, which requires financial institutions to reinvest in the communities in which they operate. Finally, it maintains enforcement over the Equal Credit Opportunity Act, which forbids discrimination when granting credit to consumers.
As noted, the Fed recently gained new authority via the Dodd-Frank Act to preserve the stability of the financial system. It also gave up the authority it formerly had in regard to consumer financial protection, including Fair Credit Reporting and Truth in Lending regulations, to the new Consumer Financial Protection Agency.
There’s no doubt that the Fed has tools at its command to influence the economy. The ability to set interest rates – not only short-term rates through the Fed Funds rate but also long-term rates via quantitative easing and other programs – is a powerful tool. In September, the Fed embarked on one of those efforts, Operation Twist. Under that $400 billion program, the Fed bought long-term bonds and sold short-term securities in an effort to keep long-term interest rates low (fig. 3).
By keeping interest rates low for an extended period of time, the Fed has been able to keep loan rates low so that businesses have the ability to borrow at a very low rate and invest in their businesses, which can lead to more job creation. Consumers with good credit also have the ability to access rock-bottom loan rates and to finance or refinance purchases in a way that leaves them with more disposable income that can be spent on discretionary purchases.
The fact that the Fed is committed to keeping interest rates low for an extended period of time – and has communicated that to the public at large – gives both business owners and consumers confidence that the low rate environment will continue. Low rates also tend to be positive for the stock market, as investors who can’t make much money in fixed income markets are driven towards riskier assets such as the stock market.
The flip side of low rates is that savers are disadvantaged. Anyone who is on a fixed income and doesn’t want to take risks in high-yield issues has a tough time finding yield in such a low-rate environment. The other potential problem is that keeping rates low for a long period of time and pumping a large amount of money into the financial system can spark inflation.
For years, many economists have predicted that inflation would increase because of the easy money policy, but it hasn’t happened yet. Inflation did rise in the winter and early spring due to rising energy prices, but those prices have recently subsided. Gas prices are down to an average of $3.74 per gallon in late May, down from $3.94 in April.
Despite the Fed’s power to set interest rates, there is a lot it can’t do in terms of the economy. It can’t directly appropriate money to help the unemployed, create jobs or fund programs as Congress and the president can. The stimulus that the Fed can provide is known as monetary stimulus, while the type that the president and Congress can provide is called fiscal stimulus.
As the Fed’s role has expanded, so has the criticism and scrutiny surrounding it. Economists, analysts and politicians have always carefully parsed the actions of the FOMC. Now, that scrutiny has expanded to encompass the entire Fed. Bernanke has embarked on a mission to surround the Fed with greater transparency and, as part of that movement, recently gave four guest lectures at George Washington University on the Fed and its evolving role.
The biggest question surrounding the Fed today is in regard to what it can – and can’t – do to stimulate the economy. Pundits are divided as to whether a third round of quantitative easing (“QE3”) will or won’t happen and if it does, whether it would be a good idea or not. It seems pretty clear that there won’t be any moves to stimulate the economy fiscally out of Washington, D.C. with an election coming up, and state governments are still in budget-cutting mode so there won’t be any stimulus coming from state capitals. So whether the Fed would embark on QE3 and buy more long-term bonds and whether such a move would help spark tepid economic growth is open to question.
The minutes of the April Fed meeting reveal that more members of the Fed are open to implementing measures to boost economic growth than were in favor of such moves at the March meeting. They appear to be more willing to act in the upcoming months if the recovery loses momentum or becomes stalled – or if outside events increase active downside risks.
The Fed has stated its intentions to keep short-term interest rates near zero through 2014. The latest signs are that inflation is fairly quiet. In April, energy prices fell again as the Consumer Price Index essentially remained unchanged from the month before. Core prices rose .2 percent for the second month in a row while retail sales and overall economic growth remained tepid. Some Fed governors continue to be optimistic that inflation will ease, allowing the Fed to continue its policy of keeping interest rates near zero without having to worry about problems with inflation. Bernanke and several other governors are still concerned about anemic job growth but admit that the Fed doesn’t have the firepower to do much to stimulate job growth (fig. 4).
On the regulatory front, the Fed is still wrestling with implementing some regulations from the Dodd-Frank Act amid the debate about how to manage so-called “Too Big to Fail” or Systemically Important Financial Institutions (SIFI). The Fed does now have the power to regulate and break up – if necessary – Systemically Important Financial Institutions, but there is disagreement about exactly how to keep these megabanks from disrupting the financial system in the future. The Fed is also working on clarifying the Volcker Rule, which empowers the Fed to force banks to cut back on the risks they take with their own money.
Will the Fed implement QE3 or will the economy muddle along enough that the Fed stands pat? Only the events of the next several months will tell. The Fed’s most recent forecasts for economic growth per gross domestic product (GDP) were between 2.5 to 3 percent for the rest of this year and next. It also hopes that the unemployment rate – currently at 8.1 percent – will fall below 8 percent next year.
If the economy doesn’t meet the Fed’s expectations for the rest of the year and into 2013, it may be more likely to act. So watching the overall rate of economic growth and the unemployment rate will likely give clues of the direction the Fed will move toward. Fed officials are now much more open about their views on the economy, so any speeches that Fed governors make or releases of minutes from recent meetings will also provide information about what the Fed is likely to do in coming months.
Christopher Bremer is the Director, Private Client Services Portfolio Management with The Northwestern Mutual Wealth Management Company. The opinions expressed are those of Christopher Bremer as of the date stated on this report and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment or security. Information and opinions are derived from proprietary and non-proprietary sources.
Northwestern Mutual Wealth Management Company, Milwaukee, WI is a subsidiary of The Northwestern Mutual Life Insurance Company, Milwaukee, WI (NM) and a limited purpose federal savings bank authorized to offer a range of financial planning, trust, fiduciary, investment advisory and investment management products and services. Securities are offered by Northwestern Mutual Investment Services, LLC, subsidiary of NM, broker-dealer, registered investment adviser, member FINRA and SIPC.
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The Federal Reserve, the central bank of the United States, provides the nation with a safe, flexible, and stable monetary and financial system.
The Dodd–Frank Wall Street Reform and Consumer Protection Act is a federal statute in the United States that was signed into law by President Barack Obama on July 21, 2010. The Act is a product of the financial regulatory reform agenda of the Democratically-controlled 111th United States Congress and the Obama administration.
The Consumer Financial Protection Bureau was established as a result of the Dodd-Frank Bill. The Bureau regulates consumer financial products and services in compliance with federal law. Even though the Bureau is placed within the Fed, it operates independently.
The Federal Open Market Committee (FOMC) consists of twelve members who meet eight times annually to review economic and financial conditions, determine the appropriate stance of monetary policy, and assess the risks to its long-run goals of price stability and sustainable economic growth.
The U.S. Department of Labor Consumer Price Indexes (CPI) program produces monthly data on changes in the prices paid by urban consumers for a representative basket of goods and services.
The Volcker Rule is a specific section of the Dodd–Frank Wall Street Reform and Consumer Protection Act originally proposed by American economist and former United States Federal Reserve Chairman Paul Volcker to restrict United States banks from making certain kinds of speculative investments that do not benefit their customers.
The gross domestic product (GDP) is the amount of goods and services produced in a year, in a country.
Systemically important financial institutions (SIFI) are financial institutions that are deemed systemically important to the global economy in the sense that the failure of one of them could trigger a global financial crisis.