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From Banking and Finance Law Daily, March 13, 2014

House committee examines the Federal Reserve’s role in credit allocation

By Colleen M. Svelnis, J.D.

The question of whether the Federal Reserve Board’s increased role in credit allocation constitutes a threat to the Fed’s independence was considered at a hearing held by the House Financial Services Subcommittee on Monetary Policy and Trade. The hearing, “Examining the Central Bank’s Role in Credit Allocation,” was held on March 12, 2014, as part of the committee’s Federal Reserve Centennial Oversight Project. Chairman John Campbell (R-Calif), in his opening statement, described the intent of the hearing—to define the lines that separate fiscal policy from monetary policy, and to ask what it means for a central bank to be independent. “Today, it is widely understood that central banks are most effective when they are independent of their national governments’ fiscal policies. However, I’m concerned that it may be time to reaffirm that independence in the wake of actions taken by the Federal Reserve during and after the 2008 financial crisis, some policies of which persist to this day,” Campbell said. He noted the Fed’s “quantitative easing” program as well as the purchase of over $1.5 trillion in mortgage-backed securities and warned, that by “engaging in this type of ‘credit allocation,’ not just by its purchases but also by its regulations, it may be encroaching into fiscal policy.”

Issues considered included whether a revision of the 1951 Accord and a reexamination of the Federal Reserve Act may be necessary to address the Fed’s participation in credit allocation policy. The committee memorandum clarified that independence preserves a central bank’s focus on price stability and protects a central bank from short-term political pressure to finance government spending.” The Fed has in recent years engaged in credit allocation policy—an objective distinct from its monetary policy mission—in three ways highlighted for discussion at the hearing.

  1. The Fed’s purchase of over $2 trillion in Treasury obligations through “quantitative easing.”

  2. The Fed’s purchase of over $1.5 trillion in mortgage-backed securities.

  3. The Fed and the banking regulators have promulgated regulations like the Volcker Rule and negotiated international capital standards under Basel III that provide strong incentives for banks to crowd into certain asset classes, particularly sovereign debt.

1951 Accord should be supplemented. Marvin Goodfriend, Friends of Allan Meltzer Professor of Economics at Carnegie Mellon University, argued that the 1951 Treasury-Fed Accord on monetary policy should be supplemented with a Treasury-Fed Accord on credit policy. Goodfriend described how the 1951 Accord ended an arrangement dating from World War II in which the Fed agreed to use its monetary policy powers to keep interest rates low to help finance the war effort. The Accord recognized Fed independence so that monetary policy might serve exclusively to stabilize inflation and the macroeconomic activity. Goodfriend stated that “Congress bestowed independence on the Fed only because it is essential for the Fed to do its job effectively. Hence, the Fed should perform only those functions that must be carried out by an independent central bank.”

Credit policy satisfies none of the conditions that make monetary policy suitable for management by an independent central bank, according to Goodfriend, but is debt-financed fiscal policy that has no effect on the general level of interest rates. He said credit policy doesn’t change aggregate bank reserves or interest paid on reserves but instead involves a fiscal policy decision to put taxpayer funds at risk in the interest of particular borrowers. “When the Fed extends credit to private or other public entities lacking the ‘full faith and credit’ backing of the US government, the Fed is allocating credit to particular borrowers, and therefore taking a fiscal action and invading the territory of the fiscal authorities,” he concluded.

Fed is overreaching. In his testimony, Lawrence White, a Professor of Economics for George Mason University, argued that the Fed’s attempts to direct the allocation of credit are overreaching, wasteful, and fraught with serious governance problems. He said that a central bank charged with the crucial task of conducting monetary policy should focus on monetary policy. Accordingly, White stated that the Fed should be removed from the formulation and imple­mentation of credit policy.

Fed conduct consistent with mandate. Josh Bivens, Ph.D., Research and Policy Director at the Economic Policy Institute testified that the conduct of the Fed in recent years—including the quantitative easing actions—“is entirely consistent with its attempt to satisfy the dual mandate of price stability and maximum employment. He agreed that the Fed’s conduct since 2008 is quite different than its conduct over much of the preceding decades, but that is simply a reflection of the extraordinary economic environment created by the Great Recession and resulting financial crisis.” In response to the questions posed for the hearing, Bivens concluded the following:

  • the Fed’s quantitative easing actions have not enabled higher levels of federal spending;

  • the Fed’s purchase of agency bonds and mortgage-backed securities have aided the housing finance sector of the economy, but because this sector was disproportionately damaged, it was appropriate action; and

  • regulations promulgated since 2008 are likely to encourage financial institutions to hold a higher share of U.S. debt in their portfolios, but that is an appropriate response to the financial crisis.

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