Charles Evans is the President of the Federal Reserve Bank of Chicago, one of the 12 regional branches of the Federal Reserve System. Mr. Evans is also a member of the Federal Open Market Committee (FOMC), the entity responsible for establishing and executing monetary policy for the United States. Mr. Evans said some dubious things this week, and I’m bothered by the lack of pitchforks and torches I’m seeing. First, a little background.
The U.S. Congress charged the Federal Reserve (let’s call it the Fed, everyone does) with two equally important economic functions: maintaining price stability and maintaining full employment. We call this the Fed’s dual mandate. To achieve these goals, Congress gave the Fed control over monetary policy, making the Fed responsible for the supply of dollars in circulation. Congress retains control of fiscal policy—taxing and spending—as required by the Constitution. (The Constitution conveniently has nothing to say about monetary policy.) Prior to 2008, the FOMC used the Fed Funds rate—the rate at which banks borrow from and lend to each other—to execute monetary policy. When the Fed wanted to stimulate the economy, it would lower the Fed Funds rate for banks, and banks would in turn lower the rates at which consumers and business could borrow. The increase in bank lending would inject more money into the economy, driving real economic activity and leading businesses to hire more workers. If, however, the supply of money increased faster than the rate at which it could be channeled into production and consumption of real goods and services, the result was inflation—more dollars chasing the same amount of goods and services. Inflation erodes the purchasing power of money, and runaway hyperinflation makes money useless, with the result being the breakdown of trade and commerce above the level of bartering. In the past, when the Fed perceived that the risk of rising inflation outweighed the risk of rising unemployment, it would raise the Fed Funds rate, curtailing lending, economic activity, and money supply. When the risks were reversed—in the view of the FOMC—the Fed Funds rate would be lowered, causing an expansion of lending, economic activity, and money supply. Monetary policy works with a significant lag, so it would be several months or more before the impact of a change in the Funds rate would be felt in the real economy. For this reason, the FOMC had to act before a bad situation—high inflation or high unemployment—manifested itself, making the rate-setting process a hit-or-miss proposition for the FOMC, and a guessing game for market participants. Sounds fun, right? Well, it sorta was.
In 2008, everything changed. The collapse of the housing market in 2007 caused a wave of mortgage defaults and delinquencies, which in turn destroyed the value of many of the mortgage-backed securities sitting on the balance sheets of the nation’s banks. When these investments were written down, bank capital disappeared, and massive institutions like Bear Stearns, Lehman Brothers, Washington Mutual and Wachovia were suddenly insolvent. The result was a near-collapse of the global financial system, and even when the FOMC cut the Fed Funds rate to zero, it wasn’t enough. Banks wouldn’t lend to each other no matter what the rate was, because the problem was confidence. It doesn’t matter what the interest rates are when seemingly-healthy banks can go belly-up tomorrow. The Fed and the U.S. Treasury took unprecedented steps to avoid a complete collapse of the economy, and began injecting money directly into the banks. This was done directly through TARP and indirectly through asset purchases. The banking system stabilized and a second Great Depression was avoided, so TARP was wound-down as banks were able to repay the Treasury and end direct government ownership. A Great Depression was avoided, but a deep recession was not, and so the Fed Funds rate remained at zero and the indirect injection of liquidity into the banks—what we call quantitative easing or QE—intensified. We’re now five years clear of the financial crisis, and what the Fed calls ‘accomodative’ monetary policy continues, with no apparent end in sight.
This brings us to Mr. Evans, who this week said that he believes the unemployment rate will not drop to 6.5% until 2015 (it’s 7.9% now) and that QE should and will continue until that time. Why 6.5%? This is the arbitrary level the Fed now considers ‘full employment.’ Never mind that when George W. Bush took office in 2001 the unemployment rate was under 5%; 6.5% is now full employment, and Mr. Evans believes pumping cash into the banks until 2015 is what it will take to get us there. What about the other half of the dual mandate, you ask? Inflation’s not a problem, according to the Fed. The Consumer Price Index (CPI) tells us that inflation is running well under 2% annually, and if anything, it could stand to be higher. Never mind that the CPI strips out food and energy prices—who needs food and energy?—and fails to properly account for the soaring cost of health care and education. Yes, inflation isn’t a problem, as long as you don’t need food, electricity, gasoline, health care or education. So that must be my issue with Mr. Evans and his colleagues, right?
Nope. I’m not even talking about the magic inflation measurements that allow the Fed to ignore its failure to maintain price stability. I’m talking about jobs. Quantitative Easing hasn’t worked, it won’t work, and it wasn’t ever going to work—not if the goal is to increase employment. Why is this the case? Because banks aren’t lending. The old system—the Fed makes it easier for banks to borrow so banks make it easier for consumers and businesses to borrow—is broken. The Fed is pumping money into the banks, and they’re hoarding it, unwilling to lend until they see concrete evidence of a recovery in employment. You see the problem: the Fed is hoping QE will increase employment by increasing lending, but the banks won’t lend until they see evidence of increased employment. The system is broken.
In part, the Fed is to blame for the lack of lending. The FOMC wants banks to lend, but the enforcement arm of the Federal Reserve—the folks I dealt with in my former life—have been forcing banks to tighten lending standards and add layers of loan review that slow down and shut down the lending process. I can’t tell the Fed which is preferable—higher hurdles for making a loan or stimulative lending practices—but it should be obvious that you can’t have both. Banks are also to blame for being overly risk-averse, and for hoarding capital reserves beyond what is necessary. Whichever party is to blame for the bottleneck the banks now represent, the reality of that bottleneck can no longer be ignored. It’s the fact that Mr. Evans and his FOMC colleagues continue to do so that should alarm market participants and members of Congress alike.
Mr. Sensitive 