The U.S. central banking system—the Federal Reserve, or the Fed—has come under heightened focus in the wake of the 2007–2009 global financial crisis, as its role in setting economic policy has dramatically expanded. Post-crisis, the Fed faced scrutiny for its unorthodox monetary policy, known as quantitative easing (QE), which helped sustain the recovery but ballooned the Fed’s total assets from $869 billion in 2007 to nearly $4.5 trillion in 2017. At the same time, the 2010 Dodd-Frank financial reform redefined the central bank’s responsibility for evaluating the health of the nation’s financial system.
Since 2015, the Fed has focused on returning to a more normalized monetary policy. Former Fed Chair Janet Yellen oversaw rising rates throughout 2016 and 2017 and announced the end of QE, a process known as tapering. President Donald J. Trump broke with precedent in 2018 by replacing Yellen with businessman and sitting Fed Governor Jerome Powell, the first non-economist to hold the post since the 1970s. Powell has supported Yellen’s approach to unwinding the Fed’s unorthodox policies, and he continued to raise interest rates despite pushback from President Trump.
The Fed’s Dual Mandate
For most of the nineteenth century, the United States had no central bank to serve as a lender of last resort, leading to a series of financial panics and banking runs. In response, Congress passed—and President Woodrow Wilson signed into law—the 1913 Federal Reserve Act. The law created the Federal Reserve System, comprising twelve public-private regional Federal Reserve banks.
Today, the Fed is tasked with managing U.S. monetary policy, regulating bank holding companies and other member banks, and monitoring systemic risk. The seven-member Board of Governors, the system’s seat of power, is based in Washington, DC and currently headed by Fed Chair Jerome Powell. Each member is appointed by the president and subject to confirmation by the Senate. The members of the Board of Governors are part of a larger board, the Federal Open Market Committee (FOMC), which includes five of the twelve regional bank presidents on a rotating basis. The FOMC is responsible for setting interest rate targets and managing the money supply.
Historically, the Fed’s monetary policy has been governed by a dual mandate: first, to maintain stable prices, and second, to achieve full employment—the definition of which is debated by economists but is often considered to mean an unemployment rate around 4 or 5 percent. The Fed has generally relied on interest rate policy to pursue these goals, varying its federal funds target rate, the rate at which banks lend to each other, by altering its purchases and sales of U.S. Treasury bonds and other government securities.
The current benchmark by which many economists judge Fed policy is known as the Taylor rule, a formula developed by Stanford economist John Taylor in 1993, which stipulates that interest rates should be raised when inflation or employment rates are high and lowered under the opposite conditions. Taylor has argued [PDF] that the Fed’s loose monetary policy in the early 2000s likely exacerbated housing price inflation and spurred the subsequent collapse of the subprime mortgage market.
The Fed’s regulatory purview also steadily expanded through the 1990s. U.S. banking changed dramatically when the Gramm-Leach-Bliley Act of 1999 legalized the merger of securities, insurance, and banking institutions, and allowed banks to combine retail and investment banking operations, which had previously been separated under the 1933 Glass-Steagall Banking Act. Gramm-Leach-Bliley also gave the Fed the authority to determine appropriate financial activities within bank holding companies and member banks. The Fed was now responsible for ensuring banks’ solvency by enforcing provisions such as minimum capital requirements, banking consumer protections, antitrust laws, and anti–money laundering policies.
The Fed Chair
Few officials in Washington enjoy the power and autonomy of the chair of the Federal Reserve. The chair acts as a spokesperson for the central bank, negotiates with the executive and Congress, and controls the agenda of the board and FOMC meetings. Analysts and investors hang on the chair’s every word, and markets instantly react to the faintest clues on interest rate policy. The chair, appointed by the president, is not directly accountable to voters, and the Fed is largely free from the whims of Congress.
After former Chairman Ben Bernanke announced his retirement in 2013, President Barack Obama was the first Democrat since 1979 to nominate the overseer of U.S. monetary policy. Obama chose Janet Yellen, a Yale-trained economist who entered public service in 1994. Yellen was confirmed by the Senate in January 2014, becoming the first woman to head the U.S. central bank.
Yellen was a strong voice at the Fed even before becoming chair, issuing early warnings about the housing crash and pushing for more aggressive monetary policy to bring down unemployment. In her first year at the helm, as the United States saw a steady recovery in the labor market, Yellen moved to wrap up the QE program and oversaw the first rise in interest rates in nearly a decade.
New presidents have almost always reappointed the sitting Fed chair to a second term, regardless of party. But after Yellen’s first term expired in February 2018, Trump replaced her with Jerome Powell, a businessman, financier, and sitting Fed governor. Though Trump criticized Yellen’s “easy money” policies during his 2016 campaign, Powell has followed her blueprint for slowly increasing interest rates—a tightening of monetary policy that Trump has also bemoaned. Like the president, however, Powell has been more skeptical about some of the Fed’s regulations, particularly on smaller banks that have faced more scrutiny in the wake of the financial crisis, and he has been more willing than Yellen to roll back some of those regulations.
Dodd-Frank: A New Mandate
Excessive risk-taking by an undercapitalized banking system helped trigger the financial crisis, and Congress passed a new set of regulations in the aftermath. The Dodd-Frank Act aimed to “address this increasing propensity of the financial sector to put the entire system at risk and eventually to be bailed out at taxpayer expense,” said a 2011 report by New York University’s Stern School of Business.
Dodd-Frank instituted a third official mandate for the Fed, empowering it to regulate systemic risk and preserve financial stability. The Fed is now required to present its findings on risky, non-bank financial firms to the Financial Stability Oversight Council, which instructs the Fed on how to sanction those institutions.
Thanks to Dodd-Frank, the Fed is also now in charge of keeping a closer eye on the solvency of major U.S. banking operations, via its supervision of “systematically important financial institutions.”
The Fed’s yearly Comprehensive Capital Analysis and Review (CCAR), launched in 2011, has become one of the most watched indicators of banks’ financial health. Through the CCAR, combined with the Dodd-Frank Act Stress Testing (DFAST), the Fed evaluates the risk exposure of the largest financial institutions operating in the United States and determines whether their capital reserves would be sufficient in the case of another extreme economic downturn.
In May 2018, Congress approved a regulatory rollback of Dodd-Frank. The Economic Growth, Regulatory Relief, and Consumer Protection Act kept most of Dodd-Frank’s regulations but raised the threshold for financial institutions to be considered “systemically important,” freeing dozens of banks from the strictest federal oversight.
Nevertheless, the post-crisis expansion of the Fed’s regulatory powers has led to a consolidation of influence in Washington. Previously, the regional reserve banks, and the New York Fed in particular, took the lead in regulating institutions under their jurisdiction. According to internal Fed strategy documents, the new oversight bodies—such as the Large Institution Supervision Coordinating Committee (LISCC), which implements the stress tests—centralize control of the regulatory process in the capital. This reorganization reflects the belief of some that the New York branch failed to oversee the major banks prior to the financial crisis.
Holes in the System: Origins of ’Systemic Risk’
Experts have sought to identify the key drivers of so-called “systemic risk,” or the financial interdependencies that allowed a seemingly limited subprime mortgage crisis to culminate in widespread panic in the United States and abroad, as well as the failure of some of the country’s most prominent financial institutions. Some critics of Fed policy partially blame the institution, especially its decision to keep the federal funds rate at 1 percent from 2003 to early 2005, which allowed for significant credit expansion.
In the 2009 book The Road Ahead for the Fed [PDF], Carnegie Mellon’s Allan Meltzer wrote that, judging by Taylor rule guidelines (see graph below) on setting interest rates, former Chair Alan Greenspan’s Fed policy was too expansive, considering that short-term interest rates remained negative as the economy continued to grow. Greenspan attributed this policy to his belief that the U.S. economy faced a risk of deflation—a decline in prices due to a tightening supply of credit—similar to Japan’s experience in the 1990s.
Does the Taylor Rule Still Apply?
Other experts point to the 1999 repeal of the Glass-Steagall Act, which led to an escalation in the number of non-bank institutions authorized to issue credit, as a catalyst for increased systemic risk. Mauro Guillen, professor of management at University of Pennsylvania’s Wharton School of Business, says the repeal of Glass-Steagall was part of a regulatory “race to the bottom” between the United Kingdom and the United States in the 1980s and 1990s as they competed to woo financial firms. Former Fed Chair Ben Bernanke has also cited lax government regulation and gaps in oversight as causes of the crisis.
One response to this critique has been the Volcker Rule. Named for former Fed Chairman Paul Volcker, who originally proposed it, the Volcker Rule refers to section 619 of Dodd-Frank. It prohibits banks with federally guaranteed deposits from various activities, including trading with some of their own funds, which supporters say will prevent banks insured by the government from taking too many risks. The rule has been controversial, however, with many Republicans, and some Democrats, expressing concerns about the difficulty of enforcement and the costs it imposes on the banking industry.
The End of Quantitative Easing
One of the fiercest criticisms of the Fed came after its November 2010 announcement that it would launch a second round of QE (known as QE2), buying $600 billion in long-term Treasury bonds to stimulate a still-struggling economy. Twenty-three economists, investors, and political strategists wrote a letter to the Fed criticizing the plan for potentially stoking inflationary pressures, weakening the dollar, and failing to bring down the jobless rate. QE2 wrapped up in June 2011. But following the S&P downgrade of U.S. debt in early August 2011, subsequent global market volatility, and fear of another recession, the Fed launched QE3 in September 2012, an open-ended program that lasted until October 2014.
The concept behind quantitative easing was to create more resources for the financial system, making banks freer to lend and the public more apt to borrow. This was needed because the Fed’s traditional response—lowering interest rates—was ineffective with rates already near zero. Though many economists argued that additional monetary easing doesn’t help if there isn’t enough demand to borrow and that fiscal policy was thus needed to boost investment in the real economy, many also considered QE to have been largely successful in staving off the worst effects of financial turmoil.
With U.S. growth rebounding and unemployment falling, the Fed ended QE purchases in 2014. However, it did not move to start shrinking its $4.5 trillion balance sheet until October 2017, when Yellen announced the Fed would begin gradually reducing its bond holdings in monthly stages through 2018. As of October 2018, the Fed’s balance sheet still held over $4 trillion in assets, well above the $869 billion it held at the onset of the financial crisis.
While markets have remained strong, some analysts worry that the reversal of the Fed’s expansionary policy could cause a repeat of the 2013 “taper tantrum,” in which the Fed’s discussion of eventually reducing purchases led to prolonged market turbulence. Another concern is that tighter Fed policy will cause the dollar to rise in value, which could put pressure on emerging-market economies that have accumulated substantial debts denominated in dollars, potentially leading to defaults or deeper economic crises.
A Return to Interest Rate Normality
In addition to balance sheet tapering, the Fed began raising interest rates back above their near-zero rate starting in December 2015, when the bank unveiled a 0.25 percent rise in the baseline federal funds rate. In announcing the first rate increase since 2006, Yellen argued that the economic recovery had “clearly come a long way, although it is not yet complete,” and said that subsequent tightening would be “gradual.” The Fed waited a full year to raise rates for a second time, which it did in December 2016, and in 2017 the rate rises accelerated. This increasing pace has continued through 2018, and the Fed has dropped language from its statements calling monetary policy “accommodative,” a sign that continued rises are expected. (Rates remain far below pre-crisis levels, however.)
Some economists lauded the Fed’s steady pace, warning that returning to normalized monetary policy is like “defusing a bomb,” in the words of market analyst Kristina Hooper. Their worry is that while the Fed’s expansionary monetary policy boosted markets and encouraged borrowing, a rapid rise in interest rates could reverse that dynamic and potentially lead to another recession.
Other observers have raised concerns that the Fed’s prolonged low interest rates may have built up risks in the economy. CFR’s Sebastian Mallaby, author of an authoritative biography of Greenspan, believes that low rates may be encouraging financial bubbles like the ones that caused recessions in 2001 and 2007. Instead of predictability, he argues, financial markets could use more uncertainty from the Fed, in the form of faster-than-expected rate increases, to dissuade Wall Street firms from taking on ever more risk.
Mohammed Aly Sergie contributed to this article.