The Federal Reserve

The Federal Reserve gets a lot of attention but folks do not always discuss what all that it does and what it should do.

The general discussion is that the Federal Reserve has a dual-mandate: keep inflation low and keep unemployment low. This misses what the Fed really does.

The most important role of the Fed is its everyday role. It keeps safe the nation’s banking and payment systems. It handles check processing and wire transfer systems. It is the banker for the Treasury Department. It acts as a potential lender for banks which are cash short each day. Those are the everyday things.

The most important non-everyday role of the Federal Reserve is its ability to do what it did when the post-Lehman liquidity crisis happened. Interbank lending stopped because no one trusted anyone else. The Fed’s intervention with massive liquidity injection was, by far, the greatest single thing which saved us from a much worse recession. In my view, this ability to inject liquidity into the banking system when there is crisis is by far the most important thing the Fed does.

Another thing the Fed does is support the publishing of scholarly articles about the economy. Some find this discomforting because such a large percent of published work on the economy (about 75%) is underwritten by the Fed.

Getting back to the two stated goals of the Fed – unemployment and inflation – I have no idea if the Fed’s QE’s have really helped unemployment. There is a risk here which concerns me. This expansion of money supply is on a scale never before seen. Generally, expanded money supply risks inflation. The Fed is likely to find itself in the near future choosing between which of its two mandates it will prefer because it may have to reduce money supply to prevent inflation and, in doing so, hurt GDP and jobs.

There is one more point I would add. Other than pay attention to inflation and unemployment the Fed should constantly monitor the value of the US$ and intervene in Forex markets as necessary. If Congress is going to revise the Fed’s goals it should add the stability of the US$. One has to believe that they, in fact, do this but it might benefit people if the Fed actually says this and if people realize that US$ stability is a prerequisite for a healthy economy.

Dodd-Frank and CFPB have also put the role of overseeing regulations in the hands of the Fed. As people object to the outcomes of these regulations the Fed will take heat. What the results of that will be is something I cannot estimate.