This article originally appeared on US News.
With the increase in the federal funds rate last week, and two expected increases in September and December, the Federal Reserve Board is gradually raising interest rates.
But the Fed's low interest rate policy is only part of its accommodating stance. The Fed also holds over $4 trillion on its balance sheets, funds that were accumulated during its cycles of quantitative easing after the 2007 to 2008 recession. Quantitative easing has left the Fed with an overstuffed balance sheet that needs to be reduced.
As Mickey Levy, chief economist for the Americas and Asia at Berenberg Capital Markets, tells me in an email, "The Fed's excessively large balance sheet does not serve any positive economic purpose, but has many downside aspects. It does not stimulate economic growth or increase bank lending. It exposes the government and taxpayers to potentially costly interest rate increases. The Fed has been insufficiently transparent about these risks and distorting impacts."
Levy, also a member of the Shadow Open Market Committee, testified on "unwinding" the Fed's balance sheet before the House Financial Services Committee in April.
The Fed should develop a plan to gradually reduce its balance sheet in order to get rid of distortions and increase certainty in financial markets. This could begin with halting reinvestment of the funds of its maturing assets, which would immediately begin to shrink its portfolio. Then, the Fed could trade mortgage-backed securities that have a long maturity for those with shorter maturities.
Accumulation of these funds has budgetary effects, and the power to do so is unprecedented. Our constitution, our history and even our common sense tell us that Congress and the executive should sort out the federal budget. They are elected and answerable to the public, and the Fed is not.
Most government agencies complain that another branch or office of government stops them from doing what they would really like to do. Call it gridlock, call it checks and balances, call it what you like, our federal government is well-designed to block extraordinary gyrations and dramatic changes in policy.
Not so with the Fed. With little more than a wink and a nod, the Fed and its chairman can purchase practically all the paper that it wants. During the Fed's program of quantitative easing after the Great Recession, the Fed was purchasing $85 billion a month in Treasuries and mortgage-backed securities.
Who within government could block the Fed from making these purchases, or pursuing almost any other action? No one, it turns out. The Fed is an agency that has largely escaped oversight. It operates without check, without balance. It is perhaps an example of Plato's benevolent prince or dictator. It appears to work when the other branches of government fail, but it offends our sense of constitutional democracy.
The Fed's loose monetary policy – quantitative easing, purchases of bonds – has resulted in record-low interest rates, and investors are still taking risks to get higher yields. Low interest rates discourage savings and encourage people to take high risks, as well as dampen bank lending. This does not lead to a healthy economy. Eight years after the end of the recession, the economy's rate of growth has never been much above 2 percent.
The Fed has a tough job. It needs to gradually raise interest rates to avoid inflation, but not so much as to plunge us into a new recession. It needs to slowly reduce its balance sheet. With annualized gross domestic product growth at about 2 percent, and retail sales stuttering, this will be no easy feat.
America is still the most powerful country in the world. We still have the largest economy. Politicians vie to become our president. But too much power in America lies with the Fed, which is answerable to no one.
Diana Furchtgott-Roth, former chief economist of the U.S. Department of Labor, is senior fellow and director of Economics21 at the Manhattan Institute.
Interested in real economic insights? Want to stay ahead of the competition? Each weekday morning, e21 delivers a short email that includes e21 exclusive commentaries and the latest market news and updates from Washington. Sign up for the e21 Morning Ebrief.
iStock Photo