Who is the Fed’s Master?
Today, everyone looked to the Fed to find out if the central bank would lower interest rates to “save” the economy.
As economist Bert Ely noted to me this morning, “The Fed may be able to bring down long-term interest rates a little bit lower, but they’re already at record lows….everyone’s expecting a bold move, but what could the Fed do? It’s out of bold moves. “
That was clear from the Fed’s choice: extending Operation Twist to the end of the year. Twist is the quasi-stimulus in which the Fed is selling short-dated Treasury bonds and buying up long-term ones. The practical effect of that in the economy is that it’s supposed to keep long-term interest-rates low, which, theoretically, helps keep the rates on mortgages manageable.
But Operation Twist has already been in effect for some time, and you can look around to see how the economy has changed, which is to say, much for the worse, and not because of the Fed. It’s because of the crisis in Europe. No matter how low our interest rates are, we can’t save Greece, Spain and Cyprus with well-priced U.S. mortgage rates.
Going into today’s announcement, the Fed was not completely out of options — but its wardrobe of options was, shall we say, threadbare. The Fed has tried nearly everything before. So why would the results be any more dramatic this time?
Still, the Fed’s move is supposed to signal an aggressive stance against a recession. If you time-travel back to yesterday, the most likely options for a dramatic Fed move were the two that involve meddling in the financial markets. (Yes, meddling in the markets is considered an “aggressive” move even though the Fed has been forced to do it for four years now.) The first was Operation Twist. The other market-based Fed trick is called “quantitative easing.” This means that the Fed buys up Treasury bonds or mortgage securities, which helps, again, keep interest rates low. But the Fed needs to be careful with any more QE: The central bank’s balance sheet is already bloated at well over $2 trillion, groaning with all the securities it has bought in the market to influence interest rates.
So the Fed’s toolbox is worn, even though it’s still there. But the question is still: Why use it? And who does it benefit?
It’s easy to see why the Fed might be lured into even lower interest rates. The fear it faces is that the global financial markets will lock up, freeze, go kaput. This happened after Lehman Brothers collapsed — and the result was an extended financial disaster. Companies couldn’t borrow. Banks couldn’t borrow. Utilities couldn’t borrow. The federal government fell down a rabbit hole of bailouts, stimulus, emergency lending and other patch-up moves that, to this day, it still hasn’t fully exited.
So with every word the Fed debates about keeping interest rates low, it has to ask: Are we there again? Does this feel like another Lehman might be waiting in the wings? That was the question not just with this meeting, but it will also likely be the question again when the Fed meets in July/August.
Unfortunately, the answer to that question – “is there another Lehman skulking?” – can only be “yes.”
Europe is still struggling with a financial crisis even though Greece has taken a step back from exiting the Euro. With global economic uncertainty poisoning the air, “the market” — that vague term for anyone dealing with large sums of money — clamors for more stimulus. Yes, it’s a hypocritical display of free-market capitalism cheering government welfare that benefits primarily traders. But as long as those traders fuel the market for bonds – which banks and companies need – their voices will carry loudly.
The Fed also has another master: The financial leaders of the Euro zone, who have dug themselves so deeply into a financial hole that the European Central Bank is on the verge of running out of money to save them. There is lots of talk about “coordinated central bank action,” and you know what that means: The Fed will have to join forces with the Bank of England, the European Central Bank and others to flood the markets with enough stimulus — and confidence — to stave off financial panic for one more day.
It’s easy to forget, with these demanding voices of urgent financial panic yelling, that the Fed does have another, quieter master: the American people, who are contending with slow growth and high levels of unemployment. Anyone who tries to save money is getting no interest. Pensioners who depend on “fixed incomes” — read: profit from interest rates — are scraping the bottom of the barrel. Forget those with mortgages. While the interest rate for a 30-year mortgage has fallen more than once to record lows recently, those who really need that help can’t get it — the Americans trapped in foreclosure, or with underwater mortgages, or sometimes just plain looking to refinance.
So the Fed can keep interest rates low, yes. Interest rates are really the only thing the Fed can truly control. But it’s sad that we’re depending on the Federal Reserve to fix the entire economy with just one tool. And it’s sad that we’ve deluded ourselves that a few quarterly changes in interest rates are capable of fixing an economy broken over the course of years.
*This post was updated to reflect the Fed’s decision on Operation Twist.
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