Bensont challenges the Fed: long-term interest rates must be moderate

The original article is from Bessant's article published in WSJ and International Economics, titled "The Federal Reserve's New 'Gain-of-Function' Monetary Policy."

This has been abridged. When laboratory experiments escape their confines, they can wreak havoc in the real world. Once unleashed, they cannot be easily put back under control. The "extraordinary" monetary policy tools unleashed after the 2008 financial crisis also transformed the Federal Reserve's policy regime, bringing unpredictable consequences. The Federal Reserve's new operating model is effectively an experiment in gain-of-function monetary policy. The Fed's use of large-scale asset purchases as a monetary policy tool when its traditional tool—the overnight interest rate—is at the zero lower bound has created significant market distortions and unintended consequences. Furthermore, it has disrupted the Fed's uniquely independent role in the American political system. Central bank independence is fundamental to America's economic success. The Fed must change course. Its standard monetary policy toolkit has become overly complex and difficult to manage, with uncertain theoretical foundations and questionable economic consequences. Gain-of-function monetary policy must be replaced by simple, measured policy tools to achieve a narrow mission. This approach is the clearest and most effective way to deliver better economic outcomes and safeguard central bank independence over the long term. Unconventional monetary experiments, not policy Following the 2008 financial crisis, the Federal Reserve was understandably determined to help revive the U.S. economy. It had just successfully modernized its traditional role as lender of last resort, helping to stabilize the financial system. This role, as described by Walter Bagehot in Lombard Street (1873), is a time-tested function of central banks in managing liquidity crises. While the complexity of modern credit markets necessitated innovation in program design, the principles guiding the Fed's interventions were well-established. Buoyed by its success in responding to the financial crisis, the Fed began to grow increasingly confident in its ability to guide the economy. This confidence was reinforced by growing frustration with the seemingly inability of political gridlock in Washington to address the economic damage wrought by the Great Recession. The mantra "central banks are the only savior" gained widespread acceptance among policymakers. Against this backdrop, the Fed expanded its liquidity tools into uncharted territory, repurposing its asset purchase program as a tool of stimulative monetary policy. This experiment ignored the fact that even changes in short-term interest rates—a relatively mature and supposedly well-understood tool—often have unpredictable effects. Assessing the transmission of monetary policy is particularly challenging when it comes to unconventional policy tools such as large-scale asset purchases (also known as quantitative easing, QE). These tools are intended to stimulate the economy through a variety of channels, none of which is fully understood. In theory, lower long-term interest rates encourage business investment and borrowing for other productive activities, thereby boosting real economic output. Higher asset prices driven by lower interest rates are expected to produce a "wealth effect" as newly affluent consumers increase spending, boosting economic growth. Furthermore, 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 rebalancing" channel. However, the Fed's precision in measuring the impact of these tools remains extremely limited. Monetary economists attempt to quantify the impact of unconventional monetary policy using equivalent short-term interest rates. According to a leading model, the Wu-Xia Shadow Fed Funds Rate, the unconventional tools employed by the Federal Reserve in the 2010s pushed the effective nominal interest rate down to -3% by May 2014. Despite such low nominal interest rates, the US economy never experienced the nominal GDP growth that this stance would have produced. Other studies have reached different conclusions. A 2017 paper from the Bank for International Settlements found that quantitative easing had a negligible effect on real output, but had a statistically significant effect on stock prices that was more than ten times the magnitude of its effect on real output. Yet then-Federal Reserve Chairman 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 it doesn't work in theory." The Fed's confidence in its powerful new tools was like a central planner assuring its people that their vast powers and foresight would bring unstoppable prosperity. But despite Bernanke's insistence, the mystery of both the intended and unintended effects of quantitative easing persisted. Unpredictable Real-World Consequences One might have thought that all these new tools, along with the concentration of U.S. financial markets on Constitution Avenue, would have given the Federal Open Market Committee (FOMC) a clearer view of where the economy was headed. At the very least, all these "gain-of-function" measures should have enabled the FOMC to more effectively guide the economy along their desired path. But this didn't happen because the Fed simply didn't understand how its new gain-of-function monetary policy worked. In its November 2009 Summary of Economic Projections, the Fed projected real GDP growth of 3% in 2010, accelerating to 4% in 2011, hoping that its new "gain-of-function" monetary tools and large fiscal deficits would stimulate the real economy. Actual growth in 2010 was close to the forecast, at 2.8%, but growth didn't accelerate, slowing to 1.6% in 2011. At the end of 2010, the FOMC still projected 4% annual growth in both 2012 and 2013. In reality, growth was only 2.3% in 2012 and 2.1% in 2013. During the first six years of this system, the Fed's one-year forecasts for real GDP had an average error of 0.6 percentage points—a sizable miss when the target was typically around 2%—and its two-year forecasts had an even larger average error of 1.2 percentage points. Cumulatively, the Fed's two-year forward forecasts overestimated real GDP by 7.6% and projected an economy that was over $1 trillion larger (in 2009 dollars) than it actually was. These repeated errors suggested that the Fed was overconfident in its own ability and the role of expansionary fiscal policy in stimulating growth. This changed when the Trump administration shifted fiscal policy toward tax cuts and deregulation to strengthen the economy's supply side. During the administration's first three years of the pandemic (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 inflation triggered by the $2.1 trillion American Rescue Plan of 2021 would be "transitory." Some price pressures did prove temporary, but the FOMC ultimately had to tighten much more than it had anticipated. At the end of 2021—despite clear signs of accelerating inflation—the Fed projected a federal funds rate of 0.9% at the end of 2022, 1.6% in 2023, and 2.1% in 2024. Even in June 2022, with inflation in full swing, the Fed still projected that interest rates would peak at 3.8% by the end of 2023, declining thereafter. In fact, the rate has remained above 4% since December 2022. The Fed's failure to foresee the surge in inflation stemmed from its flawed model. A straightforward application of supply and demand principles already raised alarm bells. Many observers at the time noted that the scale of the fiscal stimulus was far greater than the estimated output gap. Yet, the Fed—breaking with its tradition of political neutrality—openly called for stimulus and subsequently matched it with ultra-loose monetary policy. The Fed's flawed economic model also relied 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 communication and credibility. In other words, the Fed believes that simply demonstrating its commitment to low inflation is enough to maintain price stability. Former Bank of England Governor Mervyn King aptly described this approach as the "King Canute theory" of inflation, comparing it to the medieval king who was believed to command the tides. As Governor King put it, "A satisfactory theory of inflation cannot be of the form 'inflation will remain low because we say it will.'" Economic models are not politically biased. But they are based on certain beliefs about how the economy works, and these beliefs can be correlated with 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 and underestimated the effectiveness of tax cuts and deregulation. In short, the model's bias is the same political trend that has plagued much of Washington for decades: We know better than the markets. Besides misguided reliance on flawed models, the Fed's unconventional monetary tools undermined a crucial source of feedback: financial markets. The wall of liquidity created by quantitative easing flattened the cost of capital across industries and sectors, effectively drowning out the market's ability to signal early warning signs of weakness in the real economy or rising inflation. Under normal circumstances, financial markets would have served as a barometer of potential risks to the economic outlook. However, the distortions created by the Fed's actions prevented these signals from emerging in a timely manner. Side Note: The Fed's Policies—"Socialism for Investors, Capitalism for Everyone Else" Unconventional monetary policies do have significant supporters. But these sources of support raise important questions about the appropriateness of these policies. Pillars of academic economics—Ben Bernanke and Janet Yellen—pioneered the expansion of the Fed's toolkit in the 2010s. Not surprisingly, academic economists are among the most vocal proponents of the Fed's expanded role. 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 rise mechanically, while other assets are bid up by the Fed's deliberate push for investors to take on more risk. While there is little evidence that this policy led to an increase in real economic output, it clearly created an important base of support for unconventional monetary policy in financial markets, which were highly sensitive to the presence of a "Fed put" because of the Fed's repeated financial rescues. This fostered a rise in long-only investment strategies, primarily in low-cost index funds and private equity, thereby undermining the potential for capital markets to exert discipline through price discovery. Notably, critics of the Fed's unconventional tools emerged from both ends of the economics spectrum, suggesting a convergence among a small group of people—regardless of their political leanings—who possess the expertise necessary to understand the effects of quantitative easing and are not captured by the hierarchies of academic economics or market incentives. In her book, Engines of Inequality: The Fed and the Future of American Wealth (2021), progressive financial policy expert Karen Petrou documents how the Fed's pursuit of a "wealth effect" to stimulate the economy has backfired. "Unprecedented inequality makes clear that the wealth effect, while highly effective for the wealthy, is an accelerator of economic hardship for everyone else," Petrou writes. Economists' focus on the supposed benefits of the wealth effect is particularly odd because the Fed's asset purchases have a stronger impact on the discount rates that underpin asset valuations than on the cash flows that support asset prices. Asset owners are less likely to frontload consumption due to changes in the discount rate and more likely to frontload consumption due to income growth. And even if they do increase consumption, the effect is likely to reverse once the discount rate normalizes. In Petru's view, rising income and wealth inequality is a function of America's asset distribution—a reality the Fed should have taken for granted. Only the wealthiest individuals own the financial assets most directly affected by the Fed's massive asset purchases. Further down the income distribution, a significant portion of the middle class has home equity, an asset that is less sensitive to the Fed's financial market manipulation. However, the bottom 50% of the income distribution has virtually no net wealth, "mainly from cars rather than other durable or financial assets that maintain or increase their value." As a result, the Fed's pursuit of a wealth effect has the natural consequence of increasing the wealth of the most fortunate members of our society. Furthermore, Petru notes that the Fed's habit of bailing out financial asset owners effectively undermines the disciplining role that financial markets are supposed to play in the economy. Due to the Fed's continuous interventions, Petru notes that one prominent investor wrote, "Financial markets have come to expect the Fed to intervene in response to any sharp decline in stock prices." Another commentator wrote that this situation effectively created "socialism for investors, capitalism for everyone else." In his book, The King of Cheap Money: How the Federal Reserve Destroyed the American Economy (2022), journalist Christopher Leonard details a rich history of the people and meetings that drove the expansion of the Fed's toolkit. He particularly chronicles the famous 2010 dissent by former Kansas City Fed President Thomas Hoenig, who opposed the Fed's decision to begin a formal asset purchase program not aimed at financial stability but as a monetary policy tool, later known as quantitative easing (QE). Hoenig has historically shunned partisanship—he was selected to fill a Republican seat as Vice Chairman of the Federal Deposit Insurance Corporation (FDIC) and formally nominated by President Obama—and is considered a "hawk" among monetary policy practitioners. Yet, Honig's prescient objection to quantitative easing rested not on the threat of inflation but on what he called the policy's "allocative effect." For Honig, "Federal Reserve policies affect far more than just overall economic growth. Fed policies transfer money between rich and poor, and they encourage or discourage things like Wall Street speculation that can lead to devastating financial collapses." Honig's warnings came true over the following decade, as financial assets soared while little flowed into the real economy. Honig's career also underscored his commitment to sound, long-term economic thinking, which at times conflicted with the short-term urgency that drove quantitative easing decisions. During his 1991 interview with then-Federal Reserve Chairman Alan Greenspan for the Kansas City Fed presidency, Honig argued that "monetary policy requires restraint and a long-term perspective... because every action you take has long-term consequences." Greenspan apparently agreed, as he subsequently approved Honig's hiring. However, amidst the pressures of short-term economic pressures, Greenspan lost sight of this message, leading Honig to oppose a decision to cut interest rates again at the end of the 2001 easing cycle, arguing that the FOMC should take more time to assess the effects of its previous actions before lowering rates further. Subsequently, the asset bubbles fueled by the Fed's easy monetary policy in the early 2000s fueled the buildup of risks in the financial system, ultimately leading to the 2008 financial crisis. For policymakers, the pressure to be seen as "doing something" can become all-encompassing, leading to decisions like the launch of quantitative easing. Federal Reserve Chairman Ben Bernanke used this argument to defend quantitative easing at the FOMC. "It was very, very difficult... We had no good options. Doing nothing felt safer, but on the other hand, our economy was performing very poorly... So there were no safe options." Predictably, Bernanke titled his 2015 memoir "The Courage to Act," no doubt hoping to be seen as a great pioneer who pushed boundaries rather than a cautious caretaker who modestly carried out his limited mission. Monetary Contagion Strikes the Real Economy Despite the Fed's limited understanding of the relationship between gain-in-function monetary policy and real economic output, one consequence was clear: it had severe distributional consequences in American society. These consequences first became apparent during the 2008 financial crisis. According to Bagehot's classic model, central banks in such situations should provide emergency lending at penalty interest rates to ensure that liquidity operations do not mask deeper solvency problems and to prevent fraud. However, the Federal Reserve's continuous interventions during and after the financial crisis created a de facto backstop for asset owners. This led to a toxic cycle in which asset owners controlled an ever-increasing share of national wealth. Within the asset-owning class, the Fed effectively selected winners and losers by expanding its asset purchase program from Treasury bonds to private debt, with the real estate sector receiving particularly favorable treatment. The impact of these policies extended far beyond the asset owners who directly benefited from quantitative easing. In the corporate sector, the Fed's interventions have provided significant advantages to large corporations, often at the expense of smaller ones. Large companies with access to debt capital markets have been able to take advantage of historically low interest rates by securing their debt at long-term fixed rates. In contrast, smaller companies, which 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. Even more damaging are the distributional effects of gain-in-function monetary policy on households, which have strained the American social fabric. The Fed's operations along the risk and time curves have compressed interest rates and boosted asset prices. This mechanism has disproportionately benefited those who already own assets. For example, homeowners have seen their property values ​​soar. Given the structure of the US housing market, with over 90% of mortgages being fixed-rate, they are largely insulated from rising interest rates. As a result, even with rising interest rates, the housing market remains overheated, with over 70% of existing mortgages trading at rates more than three percentage points below current market rates. Meanwhile, less affluent households, priced out of the homebuying market by high interest rates, miss out on the asset appreciation that benefits wealthier households. These households also face tighter financial conditions as rising interest rates push up borrowing costs. Meanwhile, inflation—driven in part by the Federal Reserve's massive expansion of the monetary base through quantitative easing and the associated record fiscal spending—disproportionately affects lower-income Americans, further exacerbating economic inequality. This has also prevented a generation of young Americans from owning their own homes. By failing to achieve its inflation mandate, the Fed has allowed class and generational disparities to worsen. The Federal Reserve's growing footprint has also had profound implications for the political economy, placing its cherished independence in a precarious position. By expanding its purview into areas traditionally reserved for fiscal authorities, the Fed has blurred the line between monetary and fiscal policy. This is particularly evident in the Fed's balance sheet policies, which influence the allocation of credit across the economy. When the Fed purchases non-federal government debt, it directly influences which sectors receive capital, thereby intervening in areas that should be the domain of capital markets and fiscal authorities. Furthermore, the Fed's involvement in the Treasury market has brought it into the realm of public debt management, a role traditionally overseen by the Treasury Department. This entanglement between the Fed and the Treasury is worrying because it creates the impression that monetary policy is being used to accommodate fiscal needs, rather than being deployed solely to maintain price stability and promote maximum employment. The Fed's expanded toolkit also has broader consequences for the behavior of elected officials. The Fed's actions have fostered a culture within the Washington establishment that encourages reliance on the central bank to pay for poor fiscal policies. Instead of taking responsibility for fiscal decisions, past administrations and Congresses have expected the Fed to intervene when its policies led to economic dysfunction. This "central bank is the only savior" dynamic creates perverse incentives for fiscal irresponsibility, as the costs of poor governance are increasingly deferred or masked by the Fed's monetary interventions. At the heart of these concerns is the erosion of central bank independence, a cornerstone of sustainable economic growth and stability. As the Federal Reserve expands its mandate, it erodes the traditional boundaries that shielded it from political influence. Critics who argue that the Fed is overstepping its authority by engaging in fiscal or quasi-fiscal activities are correct. The Fed's missteps and arrogance in its policymaking put its credibility at risk and jeopardize its independence in its core responsibility for monetary policy. Overestimating one's own power or that of one's own institutions is a fundamental human trait. In some cases, it can even be beneficial. But for the conduct of monetary policy, it is deeply problematic. The Fed claims independence. But is it truly independent? Or is it captivated by the ghosts of its past and its own arrogance? Monetary policy fueled the housing bubble, while the Fed and other institutions' slow recognition of warning signs exacerbated the financial collapse. Despite its missteps, the Fed gained more power after the financial crisis than before it. Unfortunately, these expanded powers and lack of humility only exacerbated the Fed's missteps. Overregulation, Conflicts of Interest, and Threats to Independence Post-crisis congressional reforms significantly expanded the Federal Reserve's regulatory footprint. The 2010 Dodd-Frank Act placed all bank holding companies with assets exceeding $50 billion (later increased to $100 billion, depending on circumstances) under the Federal Reserve's supervision, authorized it to designate and supervise systemically important non-bank institutions, mandated annual stress testing and living wills, and made it the primary overseer of key clearinghouses and payment systems. The abolition of the Office of Thrift Supervision also brought its holding company supervision under the Federal Reserve. Combined with the Fed's own Basel III capital and liquidity rules, these changes transformed the central bank from a lender of last resort to the dominant microprudential regulator of the US financial industry. Fifteen years later, the results are disappointing. The 2023 failures of Silicon Valley Bank, Signature Bank, and First Republic Bank all occurred at firms subject to Fed inspections and customized stress tests. Regulators flagged vulnerabilities but failed to report them; the same staffers who wrote monetary policy briefs missed the most basic duration risk. Earlier scandals—from Wells Fargo's abusive sales practices to JPMorgan Chase's "London Whale"—also fester under Fed oversight. The core problem is structural: the Fed now regulates and lends to the banks it oversees and sets the profitability calculations for them. This is an unavoidable conflict that obscures accountability and jeopardizes the independence of monetary policy. This conflict, in turn, affects policy. A Fed wary of exposing its own regulatory failures has a direct incentive to keep liquidity ample and interest rates low, lest asset values ​​fall and banks run into trouble. Conversely, an aggressive anti-inflationary stance forces the Fed to acknowledge those failures when tightening policy reveals a fragile balance sheet. Either way, monetary policy becomes a captive of regulatory self-interest. A more coherent framework would restore institutional professionalism. The Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC) have decades of expertise in examiner-led, rules-based bank supervision. Routine safety and soundness checks, consumer protection enforcement, and prompt corrective actions should be vested in these agencies, allowing the Federal Reserve to focus on its traditional mandate of macroprudential oversight, lender of last resort liquidity, and monetary policy. Re-empowering the FDIC and OCC would strengthen accountability, rebuild the firewall between regulation and monetary policy, and help safeguard the Federal Reserve's independence while improving bank safety. The Fed's nonpartisanship has become questionable. The Fed must also address the perception of its increasing partisanship in recent years. Manhattan Institute research reveals a disturbing shift in the political composition of Reserve Bank directors. Between 2010 and 2015, the proportion of Reserve Bank directors who made political donations was roughly evenly split between the two parties, with approximately 20% going to Republicans and 20% to Democrats. However, since 2015, the percentage of directors donating to Republicans has plummeted to 5%, while donations to Democrats have risen to 35%. This shift has raised concerns that the Fed is becoming a partisan institution, undermining its neutrality and independence. Compounding this problem is the Fed's strategic engagement with the media, including offering preferential access based on the tone and content of its coverage. By using the media as a tool to advance its interests, the Fed creates the impression that it is attempting to evade good-faith oversight. This behavior undermines its accountability and further erodes trust in the institution. Supervision and monetary policy are best left to a politically independent institution. But that institution must also be accountable. Mature and responsible individuals hold themselves accountable first. This is, of course, a challenge, as we all have egos. Self-accountability should be easier for an institution, theoretically free of egos and egos. But institutional self-interest plays just as much of a role. In the case of the Federal Reserve, the evidence is clear, particularly following its adoption of a pro-functional monetary policy. The Fed has become constrained by its institutional self-interest at the expense of the national interest. It has failed to objectively assess its performance and adjust its processes accordingly. The Fed continues to evade accountability because any criticism of its performance is met with a media barrage, with legitimate criticism being called an attack on the central bank's independence. The Fed should be able to implement its policies without political pressure. Monetary policy should not be set in the White House or on Capitol Hill. But when the Fed's monetary policy produces suboptimal results, it becomes the duty of our nation's elected leaders to point out its shortcomings. Conclusion The Federal Reserve System's heavy intervention in financial markets in recent decades has led to a series of unintended consequences. While these unconventional tools were introduced to respond to exceptional circumstances, their effectiveness in stimulating economic activity remains unclear. However, they have clearly had serious distributional consequences in American society, undermining the Fed's credibility and threatening its independence. At the heart of the Fed's independence lies its credibility and political legitimacy. Both pillars have been jeopardized by the Fed's decision to expand its role beyond its traditional mission and engage in activities that amount to functional gain monetary policy. These actions have eroded the institution's insulation from political pressure and jeopardized its ability to operate as an independent entity. Going forward, the Fed must commit to reducing its distortive influence on markets. At a minimum, this could include the Fed using, and then stopping, unconventional policies like quantitative easing only in true emergencies and in coordination with the rest of the government. It could also require an honest, independent, and nonpartisan review of the entire institution and all of its activities, including monetary policy, regulatory policy, communications, staffing, and research. We now face not only short- and medium-term economic challenges, but also the potentially dire long-term consequences of a central bank that has put its own independence at risk. To safeguard its future and the stability of the U.S. economy, the Federal Reserve must reestablish its credibility as an independent institution focused solely on its statutory mandate of maximum employment, stable prices, and moderate long-term interest rates.