The Crumbling Credibility of the Fed

April 02, 2023 | Team

With the banking crisis still far from over, the Fed has been under much scrutiny as of late, and it seems that the Fed has become the perennial butt of jokes regarding its perceived incompetence. Most recently on March 29, Senator John Kennedy grilled Fed’s Vice Chair Michael Barr and established that 1) the Federal Reserve optionally chose not to stress-test Silicon Valley Bank (SVB) in 2022, even though it had legal authority to do so, 2) even if the Fed had stress-tested SVB, it would not have been able to identify SVB’s large, positive interest rate gap since they only tested for recession and low-interest rate scenarios and not inflationary scenarios, and 3) even though the FDIC supervisors knew about SVB’s problems, they were ineffectual in getting SVB to rein in its excessive risk exposure. Many people are asking why can’t the Fed walk and chew gum at the same time. In this article, we will explain why the Fed is so consistently the most incompetent guys in the room.

What Do the Fed’s Mistakes Actually Cost the Taxpayer?

Historically, the Fed’s actions or inactions have cost taxpayers billions or even trillions of dollars in wasteful mistakes. For example, over a trillion dollars of taxpayer money was lost due to the Great Financial Crisis. Recently, after the Fed kept interest rates near zero for over a decade and inflation started taking hold throughout 2021, Fed Chair Powell kept repeating his unsubstantiated mantra that inflation was transitory and would disappear by itself in an immaculate fashion without imposing any costs on anyone. Dozens of independent economists warned that they did not know what kind of kool-aid Jay Powell was drinking, and his commentary seemed out of touch with reality given the five trillion dollars that were spent on fiscal stimulus and monetary expansion. The Fed waited until March 2022 to start raising the interest rates by 25 basis points. People who took Chair Powell seriously and bought long-term US government bonds at near-zero rates are now looking at trillions of dollars in losses. 

Stories like these are not uncommon by any means. Similar episodes of artificially long periods of low interest rates followed by sudden rate hikes occurred during 2000-2007. The result was the crash of the housing market, a highly interest rate sensitive sector. One of my favorite Fed memories is the 2007 declaration by Chair Bernanke: “We believe the effect of the troubles in the subprime sector on the broader housing market will be limited and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system,” Anyone who believed Chair Bernanke’s statement faced financial ruin. It seems to be a common theme for Fed chairs.

Why Does the Fed Keep Making These Huge Mistakes?

So why can’t the Fed get it right? One possibility is that the Fed officials are simply incompetent, regardless of who is at the helm. In 2023, the Fed fell asleep at the wheel and crashed taxpayers’ hard-earned resources through their incompetence with the banking crisis (so far at $20B and likely to grow over time, to be paid for by healthier banks). How is it possible that the Fed manages to hire the most incompetent economists and is mostly wrong about everything important? To get a deeper understanding, let us explore this issue further. We will show you that in financial markets, as in the game of poker, you have to hide your cards even if you appear to be a bumbling fool in order to have any chance of winning. 

Let us go back to the mini banking crisis in mid-March. Suppose the Fed had tested the banks for losses against interest rate increases in 2022. They would then have found that hundreds of banks failed these tests. What then? Could the Fed come out and admit that hundreds of banks have failed its stress test? The answer is, likely not. Such an announcement would cause a massive panic in the banking sector. It would be problematic if the Fed identified the failing banks (causing runs against just these banks) and it would again be problematic if it did not identify the failing banks (causing runs against all banks). Even if the Fed did not intend to announce the results publicly, once undertaken, the results of such a stress test could also be leaked, once again causing widespread panic throughout the economy. 

This situation is akin to a statement by Mr. Ammar al-Khudairy, chairman of the Saudi National bank who said ‘Absolutely not,” when asked if the Saudi government would make additional investments in Credit Suisse (CS), starting a panic among CS investors. Soon after, CS faced a bank run and failed and was forced to merge into UBS for a measly $3B, and Mr. Khudairy resigned from his position due to “personal reasons.” It would have been better for himself and for the Saudi government for Mr. al-Khudairy to have lied and said, “Absolutely yes, CS is a great company and we are definitely interested in grabbing as many shares as we can.“

Similarly, in the banking crisis, there were no good outcomes once the stress-tests were undertaken. It is better for the Fed to pretend to be incompetent by not doing the test in the first place than a self-incriminatory blunderer who shoots himself in the foot by conducting a test that leads to the ruin of the banking sector. 

What are we saying here? What we are saying is that the Fed is not necessarily incompetent but rather conflicted. It is not in the Fed’s interest to look for the truth or announce the truth if the truth will hurt the Fed officials themselves or the political party in power whose support they need to stay in their powerful positions atop the totem pole.

What Makes the Fed So Conflicted

To understand why the Fed is so conflicted, it is best to understand how the monetary policy actually works. For this, we go back to the brilliant economist Robert E. Lucas, Jr. and his Nobel Prize winning academic work.

Lucas in a series of papers in the early 1970s argued that if the market participants are rational (and accurate information is widely available), then only unanticipated changes to the money supply would have an impact on output and employment. If the Fed first announced its guidance and over time increased the money supply to stimulate the economy according to this guidance, market participants will immediately infer that higher inflation will result, and adjust their requirements to buy government bonds. Increases in the money supply will not lead necessarily to a lower interest rate but possibly a higher interest rate if market participants expected inflation and required the same real rate of interest, in the absence of manipulation by state actors. In this case, output would not be boosted and there would be no Phillips curve tradeoff between inflation and unemployment. 

However, according to Lucas, the Federal Reserve could make the monetary policy work more effectively by continually fooling the investing public. If people expect 2% inflation and set the Treasury rates accordingly (say at 3%), the Fed can engage in unanticipated monetary expansion to create 4% inflation. At this point, everyone who got a 3% wage raise would think that they are earning higher real wages and would work harder. Companies would look at their higher profits, think these are real profits and invest a greater amount. Monetary policy would then be a more effective tool in supporting the economy. 

Eventually the truth would come out, of course, and everyone would realize that inflation is now 4%. Everyone who bought the government bonds at 3% yield would then be hurt. Everyone who worked harder and fell behind in real terms would lose. All the companies who invested greater resources because they believed their higher profits were higher in real terms would lose. For the monetary policy to be effective the Fed would now have to fool the people again, and engage in policies that create 5% inflation when people believe that inflation will be 4%. The cycle would start again. According to Robert Lucas, the power of the Fed derives not from announcing forward guidance about future monetary policy and following policies that strictly conform to these guidelines, but simply from fooling the investing public. 

Let us get back to the mini-banking crisis. Both Fed Chair Powell and Treasury Secretary Yellen recently pronounced that the banking sector is safe and sound. What else could they have said, that the banking sector is a time bomb sitting on $2T of unrealized capital losses? Probably not. If the Fed cannot speak the truth, it is best to ignore it altogether, or even to take it to mean the opposite. There is little or nothing to be gained from following the Fed’s prescription in this case. 

In its last meeting, the Fed raised the Fed’s funds target rate by 25 basis points. What should we learn from this rate hike? Probably not much. If the Fed had raised the rates by 50 bps, it would have been accused of being oblivious to the banking crisis. If it cut the rates or paused, it could have started another panic, suggesting that the banking problems cannot be kept under wraps without an emergency measure. The best political solution is to pretend everything is fine and press again with the consensus rate hike.

The Bottom Line

The Fed’s other liquidity tools such as the Bank Term Funding Program or the Discount Window facility are designed to hide the truth by pretending that the borrowing banks are safe and sound even when they are not. The bottom line is the Fed, far from being an independent regulatory agency, is a political entity, looking for politically acceptable solutions. A conflicted actor rather than a bumbling fool is probably a better description of the Fed. Once we realize this, the Fed disconnect should disappear.