With Larry Summers out of the running, the campaign to succeed Federal Reserve Chairman Ben Bernanke is back on. But no matter who replaces him, managing the Fed these days is a different challenge.
“The job of the Fed and the chairman has grown enormously because of the financial crisis,” says Alice Rivlin, a senior fellow at the Brookings Institution and a former Federal Reserve vice chair.
In part that’s because the Fed began using tools it had rarely, if ever, tried before, and doing so in a highly visible way: The bond-buying program known as quantitative easing, for example, or keeping track of bank balance sheets.
“The Fed always had the authority to do everything that it did in the financial crisis,” says Anne Owen, former Fed economist and now professor of economics at Hamilton College. “It just used its existing authority and because it had not done that prior to the financial crisis, it opened people’s eyes up to what the Fed can do.”
But the depth of the crisis also reset expectations of the Fed’s role for everyone from the American public to foreign central bankers. With those new expectations came new tools via Dodd-Frank financial reform legislation.
“Before the financial crisis, the Federal Reserve focused primarily on monetary policy and its role in stabilizing the economy,” says Rivlin. “It had some role in supervision of some banks, but now it has a much more important role in avoiding a meltdown in the financial sector, its supervisory role is greatly enhanced compared to before the crisis.”
The Fed is now part of a Financial Stability Oversight Council, which includes the Treasury and other government agencies to serve as an early-warning system for the types of financial problems that led to the recession.
Specifically, the Fed can look at the largest financial institutions (called SIFIs — Systemically Important Financial Institutions) and intervene if they take on too much risk, says Frederic Mishkin, professor at Columbia’s graduate school of business and a former Fed governor.
If the Fed thinks financial firms are lending too much, borrowing terms are too loose, or securities prices are “frothy” and don’t reflect economic realities, it can require banks to hold more cash reserves in case things go south.
The Fed can also require banks to hold more loans themselves, rather than packaging them and selling them as securities, so they have “skin in the game” to reduce risk, says Jared Bernstein, a former Obama administration economic adviser who is now a senior fellow at the Center for Budget and Policy Priorities.
“These are measures you can do on a cyclical basis,” says Mishkin. “You could rein them in when they’re too wild, or lower those requirements to make it easier for banks to lend,” if need be.
But the Fed now is also expected to have a economic crystal ball.
“Historically, the Federal Reserve has not been great at identifying bubbles — in financial markets, housing markets, the dot com bubble,” says Bernstein. “I just think that’s a luxury the Fed can no longer afford.”
He says the Fed needs to identify bubbles when they’re small as opposed to when they’re about to tank the economy — and then do something about it.
One historically underutilized tool, Bernstein argues, is the simple bully pulpit. By merely vocalizing suspicion that a bubble is forming, the Fed can tamp down “froth” and help restore rationality to the markets, he says.
But for all the regulatory powers and expectations, the Fed can’t single handedly prod the economy grow. “There’s always been a sense in which people overrate what the Fed can do,” says Columbia’s Mishkin.
Growth requires strong fiscal policy from Congress, and a robust economy. Unfortunately for the next Fed chair, neither of those are present. So all eyes will be on him or her.