Behind the Scenes Turmoil at the Federal Reserve
This week, the Senate confirmed Janet Yellen as the new Chairman of the Federal Reserve. At the same time, it is confirmed that her previous position as Vice Chairman and Governor will be given to Stanley Fischer, former head of Israel’s central bank (Wall Street Journal, Jan. 10, 2014). Xxx Obama’s announcement Stanley Fischer brings decades of leadership and expertise from various roles, including serving at the International Monetary Fund and the Bank of Israel. He is widely acknowledged as one of the world’s leading and most experienced economic policy minds
The move is politically controversial and will have foreign policy repercussions as Fischer has dual Israeli/US citizenship. Many, on both political sides of spectrum, are asking if such a position should be held by one who has dual loyalties. They point out that critics of Texas Senator Ted Cruz say his dual Canadian/American citizenship make him a questionable choice for president. Could Fischer’s divided loyalties hinder the development of American monetary policy in favor of Israel?
No doubt Fischer is eminently qualified economist. In addition to his position at Israel’s central bank, he also has held high-level posts at Citigroup, was chief economist of the World Bank, and First Deputy Managing Director of the International Monetary Fund. As a professor at the University of Chicago and Massachusetts Institute of Technology, he taught a generation of economists, including former Treasury Secretary Lawrence H. Summers, President George W. Bush’s economic adviser Greg Mankiw and former Federal Reserve Chairman Ben S. Bernanke.
Unlike many economists who are more comfortable in academic situations, Fischer has been a success in implementing economic policy at the IMF and Israel’s central bank. At the Bank of Israel, Fischer cut interest rates early in the global financial crisis and began raising them in 2009, the first major central bank to do so.
Fischer as central bank of Israel head helped in developing the financial sanctions against Iran for its nuclear program – a skill that may find itself useful at the Fed. He has also come out in favor of an Israeli/Palestinian agreement.
But, there is more to this than bringing on a person who was successful at implementing monetary policy in Israel. As America’s economy continues to move sluggishly along, there is turmoil in monetary circles. The Obama White House wants an economic recovery that will help Democratic election chances in November. However, the traditional tools of monetary policy used by the Federal Reserve have been ineffective and new tools introduced in the last 5 years have not been any more effective. Many are asking if the rules of economics have changed or if there is a fundamental problem that isn’t being addressed.
The answer, as one can expect, depends on one’s politics.
However, before going into that, lets do a quick survey of the Federal Reserve and its place in the US and international monetary system.
A Beginners Guide to the Federal Reserve
The Federal Reserve System (also known as the Federal Reserve, and informally as the Fed) is the central banking system of the United States. It was created on December 23, 1913, with the enactment of the Federal Reserve Act. The Federal Reserve System’s structure is composed of the presidentially appointed Board of Governors (or Federal Reserve Board), the Federal Open Market Committee (FOMC), and twelve regional Federal Reserve Banks located in major cities throughout the nation. The Federal Reserve Banks are owned by the respective banks in their districts. However, that ownership doesn’t give them any control over the policies, which are determined by the Board of Governors.
The appointment of an Israeli citizen to the Vice Chairman position has raised questions about the Federal Reserve and its relationship to other countries, especially Israel.
Basically, the Fed acts as a banker. The US Treasury has a checking account with the Fed, and tax receipts and federal expenditures go through it. Foreign governments, central banks, and international organizations also have the same ability to have an account to facilitate business in the US. They also can store securities with the Fed. However, the Fed doesn’t have any ability to authorize loans to foreign governments without US government approval and a transfer from the US Treasury account.
Although the Federal Reserve’s Open Market activities can influence foreign exchange rates, Congress has given the US Treasury the authority over international financial policy. If the Treasury decides to intervene in currency markets, it is the New York Fed that actually carries out the intervention.
One of the best known functions of the New York Fed is international gold storage. Much of the gold in the vault arrived during and after World War II as many countries wanted to store their gold reserves in a safe location. Holdings in the gold vault continued to increase and peaked in 1973, shortly after the United States suspended convertibility of dollars into gold for foreign governments. At its peak, the vault contained over 12,000 tons of monetary gold. As of 2012, the vault housed approximately 530,000 gold bars, with a combined weight of approximately 6,700 tons.
The mandate of the Fed is to keep unemployment low and keep prices stable. This is largely done through the Federal Open Market Committee. It consists of all seven members of the Board of Governors and the twelve regional bank presidents, though only five bank presidents vote at any given time (the president of the New York Fed and four others who rotate through one-year terms). The Federal Reserve System is considered an independent central bank because its monetary policy decisions do not have to be approved by the President or anyone else in the executive or legislative branches of government, it does not receive funding appropriated by the Congress, and the terms of the members of the Board of Governors span multiple presidential and congressional terms.
The Fed has several ways to influence the economy through the FOMC. The best known is open market operations, which is the Fed practice of buying and selling Treasury securities to influence the supply of government debt and the cost of money. When the Fed wants to stimulate the economy, it buys bonds, thereby increasing the price and bringing down the interest rate on the securities. When the Fed wants to put the brakes on the economy, it sells Treasuries into the market to increase the supply, lower the price and raise interest rates.
They can also impact interest rates in other ways. The most traditional Fed role is to set the federal funds rate, which banks pay to one another for overnight loans and which many consumer interest rates follow as a benchmark. The Fed can reach the desired federal funds rate in three ways: open market operations, the discount window and reserve requirements.
The Fed also sets the discount rate, which moves up and down in tandem with the federal funds rate. Banks pay the discount rate when they borrow from the regional Federal Reserve banks. When the discount rate rises, banks pay more to borrow and tend to lend less, which boosts interest rates and reduces the available credit. When the discount rate falls, banks lend more freely, flooding the market with credit and causing consumer interest rates to fall.
Finally, the Fed can influence interest rates through reserve requirements, which refer to the amount of capital that banks must hold as security for their deposits. If the Fed increases the amount required as reserves, banks will be discouraged from lending, which tightens credit availability and increases rates. If the Fed lowers reserve requirements, the reverse occurs. Typically, the Fed refrains from changing reserve requirements to influence monetary policy, unless it has no other option available, because of the uncertainty it can introduce for banks.
These are the traditional tools that the Fed has used over the last 100 years to set and manage American monetary policy. However, in the last five years, the Fed has instituted several new tools – which have been controversial and have only had a marginal impact on the American economy. In fact, former Fed Chairman Bernanke in August 2012 said these nontraditional policies, “could impair the functioning of securities markets, reduce public confidence in the Fed’s ability to exit smoothly from its accommodative policies, create risks to financial stability, and cause the possibility that the Federal Reserve could incur financial losses.
These nontraditional tools include credit easing, quantitative easing, and signaling. In credit easing, a central bank purchases private sector assets, in order to improve liquidity and improve access to credit.
Quantitative easing is buying specified amounts of long term financial assets from commercial banks and other private institutions, thus increasing the monetary base and lowering the yield on those financial assets. This is different from the traditional policy of buying or selling government bonds in order to keep interest rates at a specified target value
Signaling can be used to lower market expectations for future interest rates. For example, during the credit crisis of 2008, the US Federal Reserve indicated rates would be low for an “extended period.”
However, despite the traditional tools of monitory policy and the new methods like quantitative easing, the US economy has stumbled along. This has raised the question of, “What is the Federal Reserve doing wrong?” This is the battle that both Yellen and Fischer have entered.
The Future of Monetary Policy
So, what should the monetary policy of the Federal Reserve be? That is a difficult one to answer. In November 2011, Yellen said, “Monetary policy is not a panacea.” Yet, she holds the tiller of American monetary policy. On the other hand, Fischer has been generally supportive of the Fed’s efforts to pump money into the U.S. economy and keep interest rates low.
This is a case where much of the policy may come from Fischer. Yellen is a respected academic and policy maker, but she is known to operate best when given a chance to prepare meticulously. She is not an expert in crisis management.
Fischer has been forced to handle financial crisis on the fly. He gained extensive crisis-management experience during his tenure at the IMF in the 1990s and as Israel’s central banker during the 2008-2009 global financial crises.
But, what sort of monetary policy should the Fed follow? That is the question and there are many differing opinions – some optimistic and some pessimistic.
Yellen is worried about the ability of the Fed to impact the economy in the current situation. Yellen believes in behavioral economics, which posits that people often don’t act rationally the way economic models say they should. She feels that the Fed’s traditional powers are limited now because the economy may be caught in a “liquidity trap,” with interest rates already so low that additional injections of cash by the central bank will do little or nothing to stimulate the economy
In the pessimist camp is Lawrence Summers, who was a Clinton economic advisor and was considered by Obama to be Fed Chairman. According to him, the economic crisis isn’t over. The reason for slow growth over the last 10 years is a fundamental structural change, where the inflation-adjusted interest rate may have fallen below zero – perhaps as low as negative 2-3% – “forever.” This, according to him is caused by a glut of investment money from Asia and computer technology that has caused a decline in the cost of capital goods and reduced the need to invest.
This produces a problem for the Fed’s monetary policy tools. Zero or negative interest rates make the Fed’s open market operations ineffective. It also means the US will face long term slow economic growth. The only solution will be a new set of monetary tools to manipulate the economy.
Nobel economist Paul Krugman has a different view. He believes in more robust government sector spending. He says concerns about US fiscal deficits and debt are misplaced even in the longer term. Although there is considerable concern that global investors will lose their enthusiasm for holding ever-greater amounts of US debt – resulting in a sharp depreciation of the dollar, which would make US exports more competitive. He maintains that there is less reason to worry about the long-term debt problem and more reason to worry that fiscal contraction over the last three years has been depriving the economy of needed demand.
There are also opinions within the Federal Reserve System. David Wilcox, director of research and statistics at the Fed argues that the severity and duration of the downturn that began in December 2007 has been steadily eroding the capital stock and the size and skills of the labor force. Thus, slow US output and employment growth in the last few years is a result of the financial crisis, not of some structural change as Summers argues. Without customers, firms do not build new factories, even with low interest rates. Meanwhile, workers who have been unemployed for a long time lose their skills and drop out of the market. This means less manufacturing capacity and a less effective labor force that is unable to economically grow as fast. It also means that keeping interest rates low will not work by itself. However, Wilcox recommends keeping interest rates low as long as employment remains high, which means that he favors continued easing in 2014.
There are also the concerns of the business and financial communities that have to make decisions based on Fed policy. Richard Finger, a contributor to Forbes Magazine reflects the concerns of the business and money markets. The quantitative easing tool especially concerns them as the Fed has increased its balance sheet to $3.7 trillion. His concern, as written in Forbes is, “The Fed has no excess money or reserves…..so they simply fire up the printing presses and print out of thin air $85 billion of new money each and every month. This is money that goes directly into the money supply. Nobody knows the ultimate denouement of money printing on this scale. Germany tried “abnormal” money printing in the early 1920’s after W.W. I and the result was hyperinflation, collapse of the German economy, and the rise of Hitler.”
He also notes that Obama policy is preventing the investment that would encourage economic growth, even if there are low interest rates. Obamacare and stiffer regulations, in his mind, are a bigger impact on the economy than Fed policy.
Beset with critics on both sides, the Fed is likely to steer a middle course. Fischer is traditional and more likely to continue with the current Fed tools. He feels monetary policy can work, even under current conditions. New tools like quantitative easing and signaling can push down the long-term interest rate. And there are other tools in addition to regulating the interest rate through the FOMC like influencing the exchange rate, equity prices, the real-estate market, and the credit channel.
Obama doesn’t care what policy is implemented as long as the economy recovers quickly – preferably before the November elections. Fischer has a track record as a central bank chairman, which is something no one else has. That was probably the key factor in his choice. However, undoubtedly, the choice of an Israeli citizen as the head of America’s central bank will be considered a play towards Israeli public opinion. What real advantage it gives Israel will depend eventually on Fischer’s real loyalties.
PUBLICATIONS
Cybersecurity and Stability in the Gulf
By James Andrew Lewis
Center for Strategic and International Studies
Jan 6, 2014
The Gulf has become a flashpoint for cyber conflict. Cyberspace has become an arena for covert struggle, with the United States, Israel and other nations on one side, and Iran and Russia on the other. Iran has far outpaced the GCC states in developing its cyber capabilities, both for monitoring internal dissent and deploying hackers to disrupt or attack foreign targets. Several such attacks over the past two years were likely either directed or permitted by Iranian state authorities. Even if Iran holds back from offensive actions as nuclear talks progress, the growth in Iranian capabilities remains a potential security threat for other Gulf states. The GCC countries have begun to develop their defensive capabilities, but they will need to expand their defenses and collaborate more effectively to deter future threats.
Iraq in Crisis
By Anthony Cordesman
Center for Strategic and International Studies
January 6, 2014
As events in late December 2013 and early 2014 have made brutally clear, Iraq is a nation in crisis bordering on civil war. It is burdened by a long history of war, internal power struggles, and failed governance. It is also a nation whose failed leadership is now creating a steady increase in the sectarian divisions between Shi’ite and Sunni, and the ethnic divisions between Arab and Kurd. Iraq suffers badly from the legacy of mistakes the United States made during and after its invasion in 2003. It suffers from the threat posed by the reemergence of violent Sunni extremist movements like al-Qaeda and equally violent Shi’ite militias. It suffers from pressure from Iran and near isolation by several key Arab states. It has increasingly become the victim of the forces unleashed by the Syrian civil war.
Turkey Needs Less Money in Politics, and Less Politics in Court
By Sinan Ülgen
Carnegie Endowment
January 6, 2014
Financial Times
Until last month, one could not be blamed for thinking that nothing was rotten in the state of Turkey. The combined effect of government pressure, ubiquitous self-censorship and the conflicts of interest of media owners made reporting on corruption a taboo for the Turkish press. But this was shattered by recent allegations of high-level corruption within Prime Minister Recep Tayyip Erdogan’s government. The gravity of the allegations have already led to the resignation of four ministers and arguably represent the biggest threat to Mr Erdogan after 11 years of unchallenged rule. The irony is that Mr Erdogan’s party had come to power in the wake of a failed decade of politics dominated by corruption and nepotism. His AK party had won a popular mandate with its anti-corruption rhetoric. Even the name of the party – “ak” means clean in Turkish – reflects that. It now seems that it was unable or unwilling to eradicate Turkey’s cycle of corruption-induced political crisis.
Principle and Prudence in American Foreign Policy
By Mackubin Thomas Owens
Foreign Policy Research Institute
January 2014
U.S. foreign policy is in shambles, characterized by drift and incoherence. It is at best a-strategic at worst anti-strategic, lacking any concept of how to apply limited resources to obtain our foreign policy goals because this administration has articulated no clear goals or objectives to be achieved. The foreign policy failures of the Obama Administration are legion: the Russian “reset” that has enabled Vladimir Putin to strut about as a latter-day czar; the betrayal of allies, especially in Central Europe, not to mention Israel; snatching defeat from the jaws of victory in Iraq by failing to achieve a status of forces agreement (SOFA) that would help to keep Iraq out of the Iranian orbit; the muddled approach to Afghanistan; our feckless policy—or lack of policy—regarding Iranian nuclear weapons, not to mention Libya and Benghazi, as well as Syria. President Obama has said that he was elected to end wars, not to start them, as if wars are fought for their own purpose. Ending wars is no virtue if the chance for success has been thrown away, as it was in Iraq.
Turkey’s 2014 Political Transition From Erdogan to Erdogan?
By Soner Cagaptay and James F. Jeffrey
Washington Institute
January 2014
Policy Notes 17
Turkey will hold local and presidential elections in 2014, both of significant import. The AKP, in power since 2002, has lasted longer than any other government since the country became a multiparty democracy in 1950. Likewise, Prime Minister Recep Tayyip Erdogan has ruled Turkey longer than any other democratically elected leader. These two elections thus offer an opportunity for the AKP to strengthen its hand before the 2015 parliamentary elections.
President Rouhani and the IRGC
By Mehdi Khalaji
Washington Institute
January 8, 2014
PolicyWatch 2189
President Hassan Rouhani’s relationship with Iran’s Islamic Revolutionary Guard Corps (IRGC) is a central dynamic in the country’s politics and economy. As always, Ayatollah Ali Khamenei ultimately determines the roles of the president and the IRGC, so Rouhani has sought to pursue his economic imperatives without crossing the Supreme Leader or the military elite on the nuclear issue. Unlike previous presidents, Rouhani seems unwilling to dominate the IRGC or directly challenge its influence over various aspects of Iran’s political and economic life. Instead, his approach has been to refashion the IRGC’s functions through the Supreme Leader — who is commander-in-chief of the entire armed forces — rather than taking independent initiative. This means convincing Khamenei to improve the economy by adjusting the IRGC’s role in politics and business, limiting its influence over the public sector and weakening its ability to compete with the private sector.
