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The Fed's Dangerous 'New Normal'

May 29, 2019 in Economics

By George Selgin

George Selgin

The American public doesn’t have much appetite for
monetary matters, and most of that limited attention has been
riveted on the political fights over President Donald Trump’s
controversial nominees to the Federal Reserve Board. But
there’s a far more serious piece of news on the Fed
front.

The Fed’s once-revered independence and traditional
controls on government spending have been dangerously eroded, with
almost no public notice or debate. And unless the Fed itself or
Congress does something about it, our financial system is at
risk.

When did this happen? In a news conference in March, Fed
Chairman Jerome Powell announced that the central bank would stop
unwinding its balance sheet this September. That decision, phrased
in the typically dry language of central bank news releases,
didn’t make headlines. Yet it was a watershed: It was the
most obvious sign yet that the Fed’s program to
“normalize” monetary policy, as it had promised to do
since 2009, was coming to an end. In essence, the Fed has decided
to keep its emergency monetary powers and stick to its new methods
of managing the supply of money in the economy indefinitely.

Is the Fed becoming the
president’s piggy bank of choice?

That “new normal,” which the Fed adopted during the
financial crisis, includes novel methods for controlling interest
rates. During the crisis, those methods allowed the Fed to engage
in “quantitative easing,” meaning large-scale purchases
of government bonds and other securities. But while they helped it
fight the Great Recession, the Fed’s quantitative easing
powers also fudged the traditional boundary line between fiscal
policy, which Congress controls and which includes decisions about
government funding, and monetary policy, which the Fed controls and
which is supposed to be dedicated solely to fighting recessions and
limiting inflation.

BY BLURRING THAT boundary line, the Fed’s
new methods threaten to undermine its critically important
independence. An independent central bank ensures that neither the
president nor Congress can decide to fund special projects or tweak
economic growth by compelling the Fed to print more money. But the
longer the Fed retains its “new normal,” the more that
independence is at risk.

To understand why this new normal is so risky, you first need to
understand how we got here.

Before the 2008 financial crisis, the Fed controlled inflation
by creating or destroying bank reserves. When the Fed created
reserves, interest rates declined, banks increased their lending
and the supply of money in the economy expanded. When it supplied
fewer reserves, it checked inflation.

But after the failure of Lehman Brothers in September 2008, the
Fed started paying interest on banks’ reserves — the cash that banks must hold
to meet …read more

Source: OP-EDS

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