With right-wing Republican presidential candidates these days either calling for the Fed to be abolished (Ron Paul) or simply calling the nation’s central bank “treasonous” (Rick Perry), thinking citizens should at least be concerned about the Fed’s activities. I defended the Fed on this blog and still do. People who should have known better, unlike Perry and Paul, such as Bill Gross of the largest bond investor in the country and Jeremy Grantham, another major investor, also ignorantly criticized the Fed’s policy of buying securities no one else wanted in order to buoy the economy. Let’s be clear, the US Federal Reserve has been doing nothing short of saving this country and the world.
With downgrading sovereign debt an activity now known to the average citizen of the planet, one should be concerned about the expansion of the Fed’s balance sheet (its assets and liabilities) to over $2.5 trillion dollars today from $869 billion in 2007, before the crisis. By buying up securities it usually did not touch, such as Freddie’s and Fannie’s obligations and mortgage-backed securities with their guarantees, it has helped support financial institutions even more powerfully than the US Treasury’s much-publicized Troubled Asset Relief Program (TARP), which by the way turned the taxpayer a profit this year (see this post). (Financial institutions paid the Treasury back with interest for its capital injections.) Still, the economy is back in the doldrums, so QE2 may morph into QE3, that is, the Fed’s securities purchases (and consequent cash injections) will continue. John Maynard Keynes called this pushing on a string. Still, with fiscal stimulus not an option anymore (deficits and debt have left US debt rated below AAA at at least one rating agency), monetary policy remains the only option. So, be careful what you abolish, Ronnie?
What of the Fed’s increasing role in the economy? How will the Fed unwind its massive holdings of securities one day and who will buy them? What is the path whereby the Fed reverts back to its normal business of implementing a normal monetary policy by buying and selling Treasury securities? These are uncharted waters we are in, folks, so no one knows, not even Bernanke.
