The Ever-Expanding Role of the Federal Reserve
The role and visibility of the United States Federal Reserve (Fed) has significantly expanded from its original charge as (a) an implementer of monetary policy and (b) a stabilizer of the banking system. The Fed has now become a large-scale investment entity and bond market participant with a huge balance sheet. According the Council on Foreign Relations and the Federal Reserve, the Fed’s assets have expanded from $739 million at the end of 2002 to $3.9 trillion as of January 2019 and has been as high as $4.5 trillion. Most importantly, the Fed is expected to be largely independent of other branches of the government, including the president.
In the 1970’s, the role of Fed was officially expanded beyond monetary policy to include the mandates of promoting…” effectively the goals of maximum employment, stable prices, and moderate long-term interest rates”.1 The Fed’s power was further expanded as a result of financial deregulation: repeal of the Glass-Steagall Act in 1999; the Dodd-Frank Act of 2010 (which followed on the heels of the 2008 financial market crisis); and the ongoing political gridlock which has shifted greater responsibility to the Fed for maintaining economic growth and stability as well as managing financial system risks.
Adding to its mandates, under Dodd-Frank, the Fed has also been empowered to regulate systemic risk and preserve financial stability2. The increased volatility and structural risk in US and global financial systems has resulted in the Fed purchases of the debt of Fannie Mae and Freddie Mac; rescues of Bear Stearns and AIG; open-market purchases of Mortgage Backed Securities (MBS) and the Fed’s balance sheet transactions resulting in trillions of dollars of security purchases, which have recently been partially unwound.
In essence, the Fed has evolved from a manager of economic stability to a major player in the bond markets and a driver of stock prices.
In terms of interest rates, from a theoretical standpoint, the Fed should only directly impact short term Treasury interest rates (less than one year maturity) through its Open Market Committee (FOMC) operations and their decisions to cut, hike or maintain its Federal Funds target rate. Longer term Treasury rates (greater than one year maturities) should be driven primarily by other non-Fed factors such economic growth, federal deficits, expected inflation and supply/demand factors such as United States Treasury issuance and demand for these bonds by pensions and institutional investors. However, the Fed’s expanded mandate, large balance sheet and its increased exposure to political critique and market performance have given it an outsized role in driving longer term interest rates and stock prices.
The larger-than-life influence of the Fed has especially been manifested in the past several years since Donald Trump was elected president. In 2018, the Fed hiked short term interest rates four times, citing concerns about an overheated economy resulting from tight labor markets and global expansion. Trump blamed a major correction in the stock market in the fourth quarter of 2018 on the Fed rate hikes and called for rate cuts. He also challenged the Fed’s independence by questioning his own appointment of Jerome Powell as Fed Chairman. And in June 2019, Trump was reported to believe that Mr. Powell could be demoted from this position as Fed Chairman. While the Fed has generally maintained a wait and see stance with respect to further rate moves in 2019, the capital markets have regularly reacted to Trump’s criticisms with the assumption that rate hikes have been or will be bad, and rate cuts are good.
Are all rate cuts good? While rate cuts have extended market rallies, there are other impacts to the economy that the Fed has to take into consideration. If rates are significantly cut, there will be increased company leverage and consumer debt, which could result in the type of financial meltdown that occurred in 2008. This meltdown becomes even more likely if financial deregulation results in the excesses that led to the 2008 financial crisis. Rate cuts are also likely to hurt bank earnings, and earnings on CDs for retirees on fixed incomes will be even lower than they are currently.
We will very likely see the impact of Fed rate cuts this year as well as the back and forth between Trump and the Fed leadership on the Fed’s role.
1. Federal Reserve Bank of Chicago, “The Federal Reserve’s Dual Mandate”, June 12, 2019, https://www.chicagofed.org/research/dual-mandate/dual-mandate
2 , Council on Foreign Relations. “The Role of the Federal Reserve”, June 20, 2019, https://www.cfr.org/backgrounder/role-us-federal-reserve
NOTE: Information presented herein is for discussion and illustrative purposes only and is not a recommendation or an offer or solicitation to buy or sell any securities. Past performance is not a guarantee of future investment results.