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An Embattled Fed Fights Back


The U.S. Federal Reserve is one unloved central bank. It stands accused of inflating a bubble, then bailing out Wall Street while ignoring the little guys on Main Street. Demonstrators in Cleveland earlier this year carried signs saying things like: "Criminals are in charge of our money." Meanwhile, Congress is considering legislation that would authorize government audits of the central bank's most sensitive policy meetings. Another bill would even strip the Fed of its bank regulatory powers. "It's actually extraordinary what's happening," says Columbia University Graduate School of Business economist Frederic S. Mishkin, a former Fed governor. "The threats to the Fed's independence are extremely serious."

The Fed, though, is fighting back, and it has the Obama Administration in its corner. It's warning critics that any serious move against the Fed would jeopardize economic stability. And not only is the Fed conceding few mistakes—it's also striving to preserve every bit of its secrecy.

This game of political chicken, observers say, is likely to produce only partial victory, with the Fed hanging onto most, but not all, of its vast powers. The most likely nick would be a limit on the powers or independence of the Fed's 12 regional bank presidents, says Tom Gallagher, head of policy research at the consultancy International Strategy & Investment. Beyond that, while the Fed's hard-line stance is strengthening the case of critics who say the regulator needs to be checked, "Major players in this process [also] understand that blaming the Fed and trying to ruin the Fed as an institution is not a solution," says Ethan S. Harris, a former Fed staffer who is head of North America economics for Bank of America Merrill Lynch (BAC).

MAKING HIS CASEFed Chairman Ben S. Bernanke laid out his argument in a Nov. 29 op-ed piece in The Washington Post. He criticized both the Fed audit bill co-sponsored by Representatives Ron Paul (R-Tex.) and Alan Grayson (D-Fla.) and a financial reform plan backed by Senate Banking Committee Chairman Christopher Dodd (D-Conn.) that would transfer bank regulation away from the Fed to a new independent agency that would monitor systemic financial risk. Bernanke said both measures "are very much out of step with the global consensus on the appropriate role of central banks, and they would seriously impair the prospects for economic and financial stability in the U.S."

But anger toward the Fed is running so hot that the organization will probably have to take some kind of hit to appease the public and lawmakers. The question is where it's most willing to concede ground. Oddly enough, the Fed might be able to live with some weakened version of the auditing bill, even though it comes from Paul, its most outspoken critic. Yes, the Fed's defenders say congressional audits would politicize monetary policy by forcing rate-setters to defend their actions to Congress. On the other hand, the Fed chairman already has to endure political barbs in regular trips to Capitol Hill. "People kind of forget what abuse [former Federal Reserve Chairman Alan] Greenspan used to get when he first came to office," says Timothy A. Duy, a University of Oregon economist who writes a blog called Fed Watch.

In contrast, the Fed probably won't yield an inch on the bill from its professed friend, Dodd, to strip it of bank-regulatory powers. The Fed argues that it needs to supervise banks in order to manage monetary policy correctly, because getting rates right depends on knowing the condition of the financial system. "What they really, really want to keep is their banking regulatory powers. That goes to the core," says Joseph Engelhard, senior vice-president for Capital Alpha Partners, which tracks Washington for financial clients. For the Fed, what makes this period so dangerous is that the central bank has become a lightning rod for the severe recession and the huge bonuses going to Wall Street bankers who helped cause the mess. Congress is tapping into the public outrage. On Dec. 1, Senator Jim Bunning, the Kentucky Republican who was the only senator to oppose Bernanke's nomination in 2005, said: "His job rating would be zero minus F." Added Bunning: "He has catered to the big banks, to the Wall Street elitists, to every major money concern in the country and in the world."

Part of Bernanke's strategy is to address the public directly through forums such as 60 Minutes and The Washington Post. But even some Fed supporters say Bernanke's political intransigence may be undermining his effectiveness. In Bernanke's Nov. 29 op-ed, for example, the closest he came to an apology was to say that "the government's actions to avoid financial collapse last fall—as distasteful and unfair as some undoubtedly were—were unfortunately necessary to prevent a global economic catastrophe."

Meanwhile, the Fed's penchant for secrecy leads critics to suspect the worst. The Fed continues to fight a 2008 federal lawsuit by Bloomberg LP (which acquired BusinessWeek on Dec. 1) that seeks to find out what collateral the Fed accepted for emergency loans to financial institutions. "The problem of the secrecy is that people don't trust Wall Street, and by extension they don't trust Wall Street's interactions with the government," says Oregon's Duy. "That puts extra onus on the Fed to be more transparent, not less transparent." Merrill's Harris agrees: "The Fed over the years hasn't done itself a favor by creating this mystique."

Luckily for the Fed, it has some powerful backers, including the White House. In naming Bernanke for a second four-year term as chairman, subject to Senate confirmation, President Barack Obama said the Fed chief helped prevent another Great Depression with calm, wisdom, "bold action and out-of-the-box thinking."

Any politician tangling with the Federal Reserve also has to reckon with the bond market. If fixed-income investors fear the central bank is losing its ability to fight inflation, they will sell bonds and drive up interest rates, which would stunt economic growth. It's particularly important now for the Fed to retain its freedom of movement because there are huge sums of excess reserves in the banking system available for lending. As soon as banks resume active lending, the Fed will need to drain those reserves rapidly to keep the economy from being overstimulated. That will no doubt draw howls of protest from homebuilders and other interest groups that benefit from low rates.

While Ron Paul worries that an unconstrained Fed will allow too much inflation, the truth is more likely the opposite, says Columbia's Mishkin: A Fed that's under the thumb of a deficit-loving Congress is unlikely to be a good guardian of the dollar. In the end, that argument for Fed independence may prove decisive.

With Scott Lanman in Washington

Business Exchange: Read, save, and add content on BW's new Web 2.0 topic networkA Jolly Good AuditWillem H. Buiter, who was named Nov. 30 to be the next chief economist of Citigroup (C), wrote in his Financial Times blog 10 days earlier that auditing the Federal Reserve would be "a jolly good thing!" Buiter, a London School of Economics professor, argued that an audit would make the Fed more accountable and "could well set an important precedent for...central banks everywhere."To read Buiter's blog item, go to http://bx.businessweek.com/federal-reserve/reference/
Coy_190
Coy is Bloomberg Businessweek's economics editor. His Twitter handle is @petercoy.

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