The Federal Reserve's Unsound Policies

May 21, 2013

The Federal Reserve is increasing the long-term risk in our financial system through both its monetary and regulatory policies, says John A. Allison, president and CEO of the Cato Institute.

  • From 1914 until 2007 the Fed's balance sheet grew to $900 billion.
  • Since 2007 the balance sheet has exploded to $3.2 trillion and is growing $80 billion per month.
  • The Fed's capital ratio is currently 1.3 percent, while the average capital ratio of the largest banks is 8.0 percent.

The Fed's balance sheet has been radically expanded to hold down interest rates by buying Treasury and Freddie/Fannie bonds, significantly expanding the lending capacity of banks.

Since the U.S. dollar is the world's reserve currency, these actions have created a global currency trade war, causing misallocation of capital and lowering the global standard of living. The only reason the U.S. dollar has held its relative value is its status as the reserve currency. This allows the Fed and Congress to get away with printing money and incurring massive debt that the market would not otherwise permit.

Current Fed regulatory policy is also increasing the risk in the banking system.

  • All large banks are being forced to use the same regulatory-driven mathematical risk management models.
  • This means that all the major banks will have a strong incentive to take the same type of risk, which significantly increases the overall risk in the financial system.

In addition, by holding interest rates below what the market would create, the Fed is punishing moderate-income savers, especially older individuals.

  • Retired individuals with low to moderate net worth should not be making risky investments.
  • However, the Fed has forced down interest rates so that low-risk investments have negative real returns.
  • This means that many older individuals who hoped to live on their interest income have to consume their principle, which threatens their standard of living.
  • On the other hand the extra liquidity created by the Fed is driving higher returns in risky investments, typically owned by high-net-worth individuals.

The primary beneficiary of the Fed's low interest rate strategy is the U.S. federal government, the world's largest debtor. The federal government's annual deficit is at least $250 billion less than it would be if interest rates were normalized. It appears that the real purpose of the Fed is to obtain favorable financing for the U.S. government, at the expense of private savers.

Source: John A. Allison, "The Federal Reserve's Unsound Policies," Cato Institute, May/June 2013.

 

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