by James McBride and Andrew Chatzky
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.
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.
Few officials in Washington enjoy the power and autonomy of the chair of the Federal Reserve.
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, Trumpreplaced 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.
Dodd-Frank instituted a third official mandate for the Fed, empowering it to regulate systemic risk and preserve financial stability.
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.
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