October 2008

Conjure up the U.S. Federal Reserve in your mind’s eye, and what do you see? A wise, adept, agile and mysterious force? Bernanke & Co. teetering on the high wire? Something in between?

How you grade the Fed depends on your expectations.

“The Fed has been doing its job in terms of the level of interest rates,” says Paul Kasriel, Northern Trust’s Chief Economist. “But it is going to take some time for the financial system to rebuild its capital and avail itself of these low rates.”

That’s not happening now because the financial system has seen its capital erode and is unable to take advantage of the Fed’s interest rate cuts. So liquidity dries up as profits from lending shrink and lenders shy away as credit risk balloons.

To handle this, the Fed has taken steps to increase liquidity and deal with counterparty risk issues. It opened access to — and removed the stigma from using — the discount window. It also implemented another lending window for non-bank financial institutions, which may have helped prop up other wavering firms.

Yet even though the U.S. central bank is considered an anchor and beacon for our economy, Kasriel believes it’s a mistake to view it as the fixer for our financial woes.

“The Fed is not the answer to all economic challenges,” he says. “I think that’s really one of the lessons of this period: The Fed is not omnipotent.”

Too hands-on?
Some free-market economists, including Kasriel, think the Fed has become too hands-on and reactive in its quest to keep the economy on an even keel, especially after high-tech stocks imploded in 2000.

“I think the Fed should try to play a smaller role in the economy going forward and needs to be more neutral,” he says. “It needs to provide a reasonable amount of credit for the economy to function but not react to every zigzag in the economy or financial markets. The Fed needs to be there for liquidity issues that we’ve experienced. But it really should be more neutral.” Kasriel thinks the Fed should focus less on the level of the Fed funds rate and more on the difference between yields on 10-year Treasury notes and federal funds, which better reflects real-world credit conditions.

That spread, which also is a component in the Index of Leading Economic Indicators, on a monthly basis had increased in 2004 to as wide as 370 basis points due to easy money policy. That’s roughly three times its typical “neutral-policy” level. And as of mid-September 2008, that spread was 162 basis points, suggesting that borrowing rates remain historically low.

“The Fed kept interest rates too low for too long,” Kasriel says. “At some point, you have to take your medicine.”