The Federal Reserve System regularly is in the news, and Ben Bernanke has become a household name. But of what importance is this to the ordinary Hoosier household?
From high school U.S. history we recall that President Andrew Jackson was suspicious of Eastern bankers and refused to recharter the National Bank of the United States. Seventy-five years later, in 1913, the Federal Reserve was created by Congress to operate 12 regional banks, each owned by a consortium of local banks.
The Federal Reserve System Board of Governors consists of seven members appointed by the president for 14-year terms. The present board chairman, Ben Bernanke, was appointed by President George W. Bush and reappointed by President Barack Obama; Bernanke’s second four-year term expires Jan. 31, 2014.
The Fed, although privately owned, is operated in the public interest and reports to the U.S. Congress.
Nations pride themselves on the political independence of their monetary authorities, charged to maintain the value of their respective domestic currency by controlling inflation and providing an elastic money supply consistent with a growing economy. The Fed, which functions as the central bank of the U.S., acts as fiscal agent for the federal government.
When the federal government spends more than it collects in taxes, the Fed is required to place dollars in the government’s checking account in return for IOUs in the form of government securities. The Fed, then, either chooses to hold these securities or sell them in the open market to anyone willing to purchase them. The Fed plays a role, as well, in regulating certain financial institutions.
It is mistakenly assumed that the Fed directly controls interest rates. Interest rates, like the prices of butter and oranges, are market-driven by the supply and demand for loanable funds. Admittedly, the Fed has powerful quantitative tools that enable it to control the supply of funds and hence affect interest rates. Strictly speaking, however, the goal of the Fed should not be to determine interest rates but maintain the value of the dollar.
Generally, a sound domestic currency is reflected in the foreign exchange rate used for international transactions.
Economists can be characterized as falling into three groups with respect to how they think the Fed should operate. The first group, sometimes referred to as “gold bugs,” believe that the Fed should be limited to allowing the money supply to expand in direct proportion to the amount of gold or other precious metals held in the vaults of the Fed or Fort Knox.
The second group, advocating a monetary rule, suggests that the Fed be charged with maintaining a growth in the money supply or price level agreed upon by Congress and consistent with the long-term growth trend of the economy. This rule, depending on the turnover rate or velocity of money, permits the average price level and interest rates to vary somewhat with natural expansions and contractions of the economy but limits the discretion of Fed officials.
The third group believes that monetary policy determines not only the price level but national gross domestic product and employment, particularly in the short run. Therefore, according to the third group, the Fed should be permitted to use monetary policy to affect interest rates, private investment and consumption as well as facilitate government spending in its efforts to control the ups and downs of the business cycle.
For the first decades of its existence, the Fed’s single mandate was price stability — preserving the currency as a store of value by tightly controlling inflation. Since the 1940s, however, the Fed is required by law to consider full employment as one of its policy goals. Bernanke has justified the expansion of the Fed’s balance sheet, referred to as quantitative easing, in terms of this dual mandate.
During the recent housing crisis and recession, we have witnessed unprecedented Fed purchases, in addition to government securities, of mortgage-backed and automaker securities as well as direct lending to targeted financial institutions. The supposed goal of this monetary intervention was to boost asset values to combat potential deflation, to lower the cost of capital with lower interest rates, thereby stimulating employment.
A rising price level is sometimes used by government to make actual declines in wages more acceptable. For example, American median household income has remained at roughly $50,000 for the past four years, but adjusted for inflation, the real income of the American household has fallen. Central banks, in the U.S. and abroad, have been charged with artificially attempting to depreciate their currencies, through a variety of monetary tools, in order to stimulate exports.
The extent to which monetary activism protected the U.S. economy from a major banking collapse during the recent recession is an open question. However, monetary accommodation to political goals should certainly be avoided, and some economists and officials are concerned with the “creeping politicization” of the Fed.
The ordinary Hoosier must come to terms with the extent to which he or she has faith in the Fed to operate in terms of its primary mission of maintaining the purchasing power of the dollar at home and abroad. Otherwise, he or she must insist either on a strict rule of monetary growth/price stability or a return to a commodity-backed hard currency.
Maryann O. Keating is an adjunct scholar of the Indiana Policy Review Foundation. Send letters to firstname.lastname@example.org.