Besant challenges the Fed: must adopt a moderate and appropriate long-term Intrerest Rate.

The original text is an article by Besant published in the WSJ and International Economy, titled The Fed's new "functional gain" monetary policy

This section has been abridged. When the experimental products created by the laboratory escape their constraints, they can cause serious destruction in the real world. Once released, they cannot be easily returned to the controlled area. The "extraordinary" monetary policy tools released after the 2008 financial crisis also changed the policy framework of the United States Federal Reserve, bringing unpredictable consequences. The new operating model of the Fed is, in fact, a functional enhancement monetary policy experiment.

When its traditional tool—the overnight interest rate—is at the zero lower bound, the Fed has adopted large-scale asset purchases as a monetary policy tool, which has caused severe distortions in the market and brought unexpected consequences. Moreover, this has also disrupted the unique independent role of the Fed within the U.S. political system. The independence of the central bank is the foundation of the success of the U.S. economy.

The Fed must change course. Its standard monetary policy toolkit has become too complex and difficult to manage, its theoretical foundations are uncertain, and there are issues with economic consequences. Function-enhancing monetary policy must be replaced with simple, measurable policy tools to achieve a narrow mission. This approach is the clearest and most effective way to provide better economic outcomes and long-term safeguards for central bank independence.

Unconventional monetary experiments, rather than policy

After the 2008 financial crisis, the Fed understandably resolved to help revive the American economy. It had just successfully modernized its traditional role as the lender of last resort, helping to stabilize the financial system. As Walter Bagehot described in "Lombard Street" (1873), this role is a time-tested function of central banks in managing liquidity crises. Although the complexity of modern credit markets requires innovation in project design, the principles guiding the Fed's interventions have long been established.

Buoyed by the success in addressing the financial crisis, the Fed is becoming increasingly confident in its ability to guide the economy. The political deadlock in Washington seems unable to resolve the economic damage caused by the 'Great Recession,' and this growing frustration has reinforced that confidence. The slogan "The central bank is the only savior" has gained widespread acceptance among decision-makers.

In this context, the Fed has extended its liquidity tools into unknown territory, repurposing its asset purchase program as a tool for stimulative monetary policy. This experiment overlooks the fact that even short-term interest rate changes—a relatively mature and supposedly well-understood tool—often have unpredictable effects.

When assessing the transmission of monetary policy, the challenges are greater when unconventional policy tools such as large-scale asset purchases (also known as quantitative easing, QE) are involved. These tools aim to stimulate the economy through various channels, but none of these channels are fully understood. In theory, lower long-term interest rates encourage borrowing for business investment and other productive activities, thereby increasing actual economic output. Higher asset prices driven by lower interest rates are expected to produce a "wealth effect," as newly affluent consumers increase spending, thereby promoting economic growth. Additionally, reducing the supply of government securities in the market is intended to push investors toward riskier investments, thereby stimulating greater economic activity through the so-called "portfolio balance" channel.

However, the accuracy with which the Fed measures the impact of these tools remains extremely limited. Monetary economists have attempted to quantify the effects of unconventional monetary policy using an equivalent short-term interest rate. According to a leading model—the Wu-Xia Shadow Fed Funds Rate, the unconventional tools adopted by the Fed in the 2010s had lowered the effective nominal rate to -3% by May 2014. Despite such a low nominal rate, the U.S. economy has never experienced the nominal GDP growth that this position should have brought.

Other studies have drawn different conclusions. A paper by the Bank for International Settlements in 2017 found that the impact of quantitative easing on real output is negligible, but its statistically significant impact on stock prices is more than ten times that of its impact on real output. However, then-Fed Chair Ben Bernanke had no doubt about the effectiveness of unconventional monetary policy, famously stating in 2014: "The problem with quantitative easing is that it works in practice but not in theory."

The Fed's confidence in its powerful new tools is akin to a central planner assuring its people that their grand powers and foresight will bring about unstoppable prosperity. However, despite Bernanke's insistence, the mysteries of both the expected and unexpected effects of quantitative easing remain.

Unpredictable Consequences in the Real World

People may think that all these new tools and the centralization of the U.S. financial markets on Constitution Avenue would provide the Federal Open Market Committee (FOMC) with a clearer view of the economic direction. At the very least, all these "functional gains" should allow the FOMC to more effectively steer the economy towards the path they desire. However, this has not happened because the Fed fundamentally does not understand how the new functional gains-based monetary policy operates.

In its November 2009 "Economic Forecast Summary", the Fed predicted that real GDP would grow by 3% in 2010 and accelerate to 4% in 2011, hoping that its new "functional gain" monetary tools and large fiscal deficits would stimulate the real economy. The actual growth in 2010 was close to the forecast at 2.8%, but growth did not accelerate, instead slowing to 1.6% in 2011. At the end of 2010, the FOMC still predicted annual growth rates of 4% for both 2012 and 2013. In reality, the growth was only 2.3% in 2012 and 2.1% in 2013.

In the first six years of this system, the Fed's one-year forecast error for real GDP averaged 0.6 percentage points—when the target value is usually around 2%, this is a considerable mistake—and the two-year forecast error averaged even larger, at 1.2 percentage points. Cumulatively, the Fed's two-year ahead forecasts overestimated real GDP by 7.6%, with the predicted economic size exceeding the actual results (in 2009 dollars) by over $1 trillion. These repeated mistakes indicate that the Fed has overconfidence in its own abilities and the role of expansionary fiscal policy in stimulating growth.

When the Trump administration shifted fiscal policy towards tax cuts and deregulation to strengthen the supply side of the economy, the situation changed. During the three years before the pandemic under this administration (2017-2019), the Fed's one-year growth forecasts were consistently low. However, after President Biden's election, optimism about fiscal stimulus resurfaced. The most obvious example was the assertion that the inflation caused by the $2.1 trillion American Rescue Plan of 2021 would be "temporary". Some price pressures did prove to be temporary, but the FOMC ultimately had to tighten much more than it had expected.

At the end of 2021—despite clear signs of accelerating inflation—the Fed predicted that the federal funds rate would be 0.9% by the end of 2022, 1.6% in 2023, and 2.1% in 2024. Even in June 2022, when inflation exploded, the Fed still forecasted a peak rate of 3.8% by the end of 2023, after which it would decline. In fact, since December 2022, this rate has remained above 4%.

The Fed failed to foresee the surge in inflation due to its flawed models. The direct application of supply and demand principles had already raised alarms. At that time, many observers pointed out that the scale of fiscal stimulus far exceeded the estimated output gap. However, the Fed—breaking its tradition of political neutrality—publicly called for the implementation of stimulus, and subsequently paired it with ultra-loose monetary policy.

The Fed's erroneous economic model relies on a fundamentally flawed and self-reinforcing assumption: that inflation is primarily determined by inflation expectations, which in turn are influenced by the Fed's own communications and credibility. In other words, the Fed believes that merely stating its commitment to low inflation is sufficient to maintain price stability. Former Bank of England Governor Mervyn King aptly described this approach as the "King Canute theory of inflation," likening it to the medieval king who was thought to be able to command the tides. As King stated: "A satisfactory theory of inflation cannot take the form of 'inflation will remain low just because we say it will.'"

Economic models have no political bias. However, they are based on certain beliefs about how the economy works, which may be related to various political views. The FOMC has consistently overestimated its ability to stimulate real growth and control inflation. It has overestimated the effectiveness of spending-based fiscal policy while underestimating the effectiveness of tax cuts and deregulation. In summary, the bias of its models is similar to the political tendencies that have plagued much of Washington for decades: we know better than the market.

In addition to the erroneous reliance on flawed models, the Fed's unconventional monetary tools have also undermined an important source of feedback: the financial markets. The liquidity wall created by quantitative easing flattened the capital costs across industries and sectors, effectively drowning out the market's ability to send warning signals when signs of weakness in the real economy or rising inflation appeared. Under normal circumstances, financial markets could have served as a barometer for potential risks to the economic outlook. However, the distortions caused by the Fed's actions have prevented these signals from emerging in a timely manner.

Note: The Fed's policy - "Socialism for Investors, Capitalism for Everyone Else"

Unconventional monetary policy indeed has important supporters. However, the sources of this support raise significant questions about the appropriateness of these policies. Pillars of the academic economics community—Ben Bernanke and Janet Yellen—pioneered the expansion of the Fed's toolbox in the 2010s. Unsurprisingly, academic economists are among the strongest advocates for the expanded role of the Fed.

The financial markets are another major proponent of unconventional monetary policy. This is not surprising, as the Fed's monetary innovations are designed to work by boosting asset markets. As the Fed lowers interest rates, the prices of fixed income instruments mechanically rise, while other assets are elevated due to the Fed's deliberate push for investors to take on more risk. Although there is little evidence that this policy has led to an increase in actual economic output, it has clearly created an important support base for unconventional monetary policy in the financial markets. The financial markets are highly sensitive to the existence of the "Fed put," as the Fed has repeatedly conducted financial rescues. This has fueled an increase in long-only investment strategies, primarily low-cost index funds and private equity, thereby undermining the potential for capital markets to exert discipline through price discovery.

It is worth noting that critics of the Fed's unconventional tools appear at both ends of the economics field, indicating a convergence among a small group of individuals—regardless of political leanings, they possess the expertise necessary to understand the effects of quantitative easing and are not captured by the hierarchy of academic economics or market incentives.

Progressive financial policy expert Karen Petrou documents in her book "Engine of Inequality: The Fed and the Future of American Wealth" (2021) how the Fed's pursuit of the "wealth effect" to stimulate the economy has backfired. Petrou writes: "The unprecedented inequality clearly demonstrates that the wealth effect is very effective for the rich but serves as an accelerator of economic distress for others." Economists' focus on the so-called benefits of the wealth effect is particularly strange, as the Fed's asset purchases have a stronger effect on the discount rate of asset valuations than on the cash flows that support asset prices. Asset owners are less likely to consume early due to changes in the discount rate and more likely to consume early due to income growth. Moreover, even if they do increase consumption, this effect could reverse once the discount rate normalizes.

According to Petrou, the exacerbation of income and wealth inequality is a function of asset distribution in the United States — the Fed should regard it as a given. Only the wealthiest individuals possess financial assets most directly affected by the Fed's large-scale asset purchases. Looking further down, a significant portion of the middle class holds home equity, but this asset is less sensitive to the Fed's manipulation of financial markets. However, the bottom 50% of income distribution has almost no net wealth, "mainly coming from cars rather than other durable or financial assets that can retain or appreciate in value." As a result, the Fed's pursuit of the wealth effect naturally increases the wealth of the most fortunate members of our society.

In addition, Petru pointed out that the Fed is accustomed to rescuing financial asset holders, which actually undermines the disciplinary role that financial markets should play in the economy. Due to the Fed's continuous interventions, Petru noted that a prominent investor wrote: "Financial markets have anticipated that the Fed will intervene in the event of any sharp drop in stock prices." Another commentator wrote that this situation has actually created a scenario of "socialism for investors and capitalism for everyone else."

Journalist Christopher Leonard details the rich history of the figures and meetings that drove the expansion of the Fed's toolbox in his book "The Lords of Cheap Money: How the Fed Destroyed the American Economy" (2022). He specifically records the famous dissent of former Kansas City Fed President Thomas Hoenig in 2010, who opposed the Fed's decision to begin a formal asset purchase program that was not aimed at financial stability but rather served as a monetary policy tool, later known as quantitative easing (QE). Hoenig historically avoided partisan identification—he was elected as a Republican seat to fill a vacancy on the Federal Deposit Insurance Corporation (FDIC) and was formally nominated by President Obama—and is considered a "hawk" among monetary policy practitioners.

However, Honig's far-sighted opposition to quantitative easing does not stem from the threat of inflation, but from what he calls the policy's "allocative effect." For Honig, "the Fed's policies go far beyond affecting overall economic growth. The Fed's policies transfer funds between the rich and the poor, and they encourage or suppress things like Wall Street speculation that can lead to catastrophic financial collapse." Honig's warnings proved true in the following decade, as financial assets skyrocketed while almost none flowed into the real economy.

Hoenig's career also highlights his commitment to a sound long-term economic mindset, which sometimes conflicts with the short-term urgency of pushing for quantitative easing decisions. In his 1991 interview for the position of president of the Kansas City Fed with then-Fed Chairman Alan Greenspan, Hoenig argued that "monetary policy needs to be restrained and forward-looking... because every action you take has long-term consequences." Clearly, Greenspan agreed at the time, as he subsequently approved Hoenig's hiring. However, under the pressure of short-term economic stress, Greenspan overlooked this message, leading Hoenig to oppose a decision to cut interest rates again at the end of the easing cycle in 2001, as Hoenig believed the FOMC should take more time to assess the effects of its previous actions before further rate cuts. Subsequently, the asset bubble triggered by the Fed's loose monetary policy in the early 2000s contributed to the accumulation of risk in the financial system, ultimately leading to the financial crisis of 2008.

For decision-makers, the pressure to be seen as "doing something" can become all-encompassing, leading to decisions like initiating quantitative easing. Fed Chairman Bernanke defended quantitative easing at the FOMC with this reasoning. "It's very, very difficult... We don't have good choices. Doing nothing feels safer, but on the other hand, our economy is performing very poorly... So there are no safe choices." It is foreseeable that Bernanke titled his 2015 memoir "The Courage to Act," and without a doubt, he wants to be seen as a great pioneer pushing boundaries rather than a prudent caretaker executing his limited mission.

Monetary contagion invades the real economy

Although the Fed has a limited understanding of the relationship between functional gain monetary policy and actual economic output, one outcome is clear: it has caused severe distributional consequences in American society. These consequences first became apparent during the 2008 financial crisis. According to the classic model by White, the central bank should provide emergency loans at punitive interest rates in such cases to ensure that liquidity operations do not obscure deeper solvency issues and to prevent fraud.

However, the Fed's continuous interventions during and after the financial crisis created a de facto safety net for asset owners. This led to a harmful cycle where the share of national wealth controlled by asset owners grew larger. Within the asset owner class, the Fed effectively chose winners and losers by expanding its asset purchase program from government bonds to private debt, with the real estate sector receiving particularly favorable treatment.

The impact of these policies extends far beyond the asset owners who directly benefit from quantitative easing. In the corporate sector, the Fed's intervention provides a clear advantage to large companies, often at the expense of small firms. Large companies that can access the debt capital markets are able to lock in their debt at historically low interest rates. In contrast, small companies that tend to rely on floating-rate bank loans found themselves squeezed by rising borrowing costs when the Fed was forced to raise interest rates in 2022.

More destructively, the distribution effects of functional gain monetary policy on households have caused the social structure of the United States to become strained. The Fed's operations along the risk and time curve have compressed interest rates, pushing up asset prices. This mechanism disproportionately benefits those who already own assets. For example, homeowners have seen their property values soar. Given the structure of the U.S. housing market, over 90% of mortgages are fixed-rate, essentially shielding them from rising interest rates. As a result, even as interest rates rise, the real estate market remains overheated, with over 70% of existing mortgage rates being more than three percentage points lower than current market rates.

At the same time, less wealthy families excluded from the housing market by high interest rates have missed out on the asset appreciation that benefits wealthy families. As rising rates push up borrowing costs, these families also face tighter financial conditions. Meanwhile, inflation—partly driven by the Fed's massive expansion of the monetary base through quantitative easing and its coordination with record fiscal spending—disproportionately affects low-income Americans, further exacerbating economic inequality. This has also made it impossible for a generation of young Americans to own their homes. By failing to achieve its inflation mandate, the Fed has allowed class and generational gaps to worsen.

Unconventional monetary policy threatens the health of political systems

The growing footprint of the Fed has also had a profound impact on the political economy, placing its precious independence in a precarious position. By extending its authority into areas traditionally reserved for fiscal authorities, the Fed has blurred the lines between monetary policy and fiscal policy. This is particularly evident in the Fed's balance sheet policies, which affect the allocation of credit throughout the economy. When the Fed purchases non-federal government debt, it directly influences which sectors receive capital, thereby intervening in areas that should belong to the capital markets and fiscal authorities.

In addition, the Fed's involvement in the treasury market has placed it in the realm of public debt management, a role traditionally overseen by the Treasury. This entanglement between the Fed and the Treasury is concerning because it creates the impression that monetary policy is being used to accommodate fiscal demands, rather than being deployed solely to maintain price stability and promote maximum employment.

The expanded toolbox of the Fed also has broader implications for the behavior of elected officials. The actions of the Fed have fostered a culture among the old establishment in Washington that encourages reliance on the central bank to bail out poor fiscal policy. Past governments and Congress have not taken responsibility for fiscal decisions but have instead expected the Fed to intervene when its policies lead to economic dysfunction. This dynamic of "the central bank as the only savior" creates improper incentives for fiscal irresponsibility, as the costs of poor governance are increasingly postponed or obscured by the Fed's monetary interventions.

At the core of these concerns is the erosion of central bank independence, which is the cornerstone of sustainable economic growth and stability. As the Fed expands its scope of authority, it erodes the traditional boundaries that keep it free from political influence. Critics who believe that the Fed oversteps its bounds by engaging in fiscal or quasi-fiscal activities are correct.

The Fed's mistakes and arrogance in decision-making put its credibility at risk, jeopardizing its independence in the core responsibilities of monetary policy. Overestimating oneself or one's institution is a fundamental human trait. In some cases, it can even be beneficial. But for the execution of monetary policy, it is highly problematic. The Fed claims it needs to be independent. But is it really independent? Or is it captured by the ghosts of its past and its own hubris? Monetary policy fueled the real estate bubble, while the Fed's and other institutions' slow recognition of warning signs exacerbated the financial collapse. Despite its shortcomings, the Fed gained more power after the financial crisis than it had before. Unfortunately, this expanded power and lack of humility will only further increase the Fed's mistakes.

Overregulation, Conflicts of Interest, and Threats to Independence

The reforms following the congressional crisis greatly expanded the regulatory footprint of the Federal Reserve System. The Dodd-Frank Act of 2010 placed all bank holding companies with assets over $50 billion (later changed to $100 billion, depending on the situation) under Fed supervision, authorizing it to designate and regulate non-bank institutions that are systemically important, mandate annual stress tests and living wills reviews, and make it the primary overseer of key clearinghouses and payment systems. The abolition of the Office of Thrift Supervision also incorporated the regulation of its holding companies into the Fed. Coupled with the Basel III capital and liquidity rules established by the Fed itself, these changes transformed the central bank from a lender of last resort into a microprudential regulator dominating the U.S. financial sector.

Fifteen years have passed, and the results are disappointing. The collapses of Silicon Valley Bank, Signature Bank, and First Republic Bank in 2023 all occurred under the scrutiny and customized stress tests of the Fed. Regulators flagged vulnerabilities but failed to report them; the same employees who drafted monetary policy briefs missed the most basic duration risks. Earlier scandals—from Wells Fargo's sales practice abuses to JPMorgan's "London Whale"—also worsened under Fed oversight.

The core issue is structural: the Fed currently regulates and lends to the banks it supervises and sets profit calculation methods for these banks. This creates an unavoidable conflict that blurs accountability and jeopardizes the independence of monetary policy.

This conflict, in turn, affects policy. A Fed concerned about exposing its own regulatory failures has a direct motive to maintain ample liquidity and low interest rates to prevent asset values from falling and banks from getting into trouble. Conversely, an aggressive anti-inflation stance forces the Fed to acknowledge those failures when tightening policy reveals fragile balance sheets. In either case, monetary policy becomes a captive of regulatory self-interest.

A more coherent framework would restore the specialization of regulatory agencies. The Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC) have decades of expertise in rule-based bank regulation led by examiners. The authority for routine safety and soundness examinations, consumer protection enforcement, and immediate corrective measures should belong to these agencies, allowing the Fed to focus on macroprudential supervision, lender-of-last-resort liquidity, and traditional monetary policy tasks. Re-empowering the FDIC and OCC will strengthen accountability, rebuild the firewall between regulation and monetary policy, and help safeguard the independence of the Fed while enhancing the safety of banks.

The Fed's nonpartisan status has become questionable

The Fed must also address the increasingly partisan perception it has developed in recent years. Research from the Manhattan Institute reveals an unsettling shift in the political composition of reserve bank directors. Between 2010 and 2015, the proportion of reserve bank directors making political donations was roughly balanced between the two parties, with about 20% donating to the Republican Party and 20% to the Democratic Party. However, since 2015, the proportion of directors donating to the Republican Party has plummeted to 5%, while the proportion donating to the Democratic Party has risen to 35%. This shift has raised concerns that the Fed is becoming a partisan institution, undermining its neutrality and independence. Complicating the issue further is the strategic engagement of the Fed with the media, including providing preferential access based on the tone and content of reported stories. By leveraging the media as a tool to advance its interests, the Fed creates the impression that it is trying to evade goodwill oversight. This behavior undermines its accountability and further erodes trust in the institution.

Regulation and monetary policy are best left to a politically independent institution. However, this institution must also be responsible. Mature and responsible individuals are primarily accountable to themselves. Of course, this is a challenge, as we all have egos. For an institution, self-accountability should be easier since it theoretically lacks psychology and ego. But the institution's own interests play the same role. In the Fed, the evidence is clear, especially after its adoption of function-enhancing monetary policy. The Fed has become constrained by its own institutional interests at the expense of national interests. It has not objectively assessed its performance and adjusted its processes accordingly.

The Fed continues to evade accountability, as any criticism of its performance is met with media outcry claiming that legitimate criticism is an attack on the independence of the central bank. The Fed should be able to implement its policies without political pressure. Monetary policy should not be formulated in the White House or on Capitol Hill. However, when the Fed's monetary policy yields suboptimal results, pointing out the Fed's shortcomings becomes the duty of our nation's elected leaders.

Conclusion

The Federal Reserve's heavy intervention in financial markets over the past few decades has led to a series of unintended consequences. While these unconventional tools were introduced to address specific situations, their effectiveness in stimulating economic activity remains unclear. However, they have evidently caused serious distributional consequences in American society, undermined the Fed's credibility, and threatened its independence.

The core of the Fed's independence lies in its credibility and political legitimacy. Both of these pillars have been undermined by the Fed's decision to expand its role beyond its traditional mission and engage in activities equivalent to functional-enhancing monetary policy. These actions have eroded the insulation of the institution from political pressures, jeopardizing its ability to operate as an independent entity.

Looking to the future, the Fed must commit to reducing its distorting impact on the market. At the very least, this may involve the Fed only utilizing and then halting unconventional policies like quantitative easing in true emergencies and in coordination with other government departments. It may also require an honest, independent, and nonpartisan review of the entire institution and all its activities, including monetary policy, regulatory policy, communication, staffing, and research. We are now facing not only short-term and medium-term economic challenges but also the terrible long-term consequences that a central bank potentially jeopardizing its own independence may bring. To secure its future and the stability of the U.S. economy, the Fed must re-establish its credibility as an independent institution focused solely on its statutory mission of maximizing employment, stabilizing prices, and maintaining moderate long-term interest rates.