How Fed Can Reform Itself to Pre-Empt Trump-Inspired Overhaul

One thing we learned during the election is that details are not Donald Trump's strong suit. What is? His intuition about what a big part of the American electorate wants.

And what they want is a solution to income inequality. The rich are getting richer, the poor are getting poorer and voters aren't going to take it anymore. Given exit polling showing that a surprising percentage of voters for Trump would have preferred Bernie Sanders, it is only a matter of time before the new administration takes radical action to address economic opportunity and fix lagging middle-class income.

The Trump team surely will not approach economic policy as the Fed has done. The new administration will instead craft economic policy by trying to force the Fed out of the way so markets can do the magic in which Trump so strongly believes.

Shortly before the election, I laid out how monetary and regulatory policy affects income and wealth distribution to a group of global central bankers. Many told me how worried they were about the inadvertent impact of policies meant only as crisis remedies that, left in place for eight years and counting, now determines who wins and who loses in the financial market. Still, they thought they had time to do more research, refine definitions, test hypotheses and attend a few more conferences. I didn't think they had that luxury then and I know now for sure that there isn't time for still more study. Central bankers and financial regulators must act quickly or their discretion to modify current policy will be replaced by public determination to blow it up.

In the U.S., monetary policies intended to advance employment have added some jobs, but have cost a lot in terms of wealth distribution. Add in ultralow interest rates and it gets still harder for low- and moderate-income people to put anything aside to ensure secure retirement, handle health costs, buy a first home and send kids to college. Add in also the impact of post-crisis regulation and the combined distributional impact of eight years of well-intended financial policies becomes still clearer.

Yet the Fed can still act to address problems with its policy before Congress and the Trump administration force the Fed to intervene. In effect, the central bank likely has about six months to deal with policy reforms constructively before its critics begin to act destructively.

Up to now, each of the Fed's actions to try and promote growth made sense in its own context at its own time. But taken together, they are turning toxic for economic opportunity and, as the election proved, national harmony. Here's how each layer of U.S. financial policy works to the disadvantage of low- and moderate-income households and what the Fed must do to recognize its new reality proactively:

The Fed's Portfolio

The central bank needs to address how its asset purchases are holding back the return on investments for low- and moderate-income Americans.

The Fed's balance sheet now stands at an astonishing $4.5 trillion. While this broad reach into the capital markets helped strengthen the recovery, it was also a direct cause of global asset valuations. Those values are now set at least as much by the Fed's desires as by other market realities. A recent study from the Bank for International Settlements shows not only that U.S. wealth inequality has increased dramatically since the financial crisis, but also that a major contributor since 2008 is the return available on the assets wealthier people hold (stocks and bonds) versus the primary investment — a home — available to low- and moderate-income households.

Financial-asset valuations have soared in part because the Fed has bought up so much, with ultralow rates also making more traditional investments suboptimal compared to market-driven instruments. Americans who own a home have begun to see some price improvements that may erase a bit of the sharp rise in wealth distribution towards the richest households, but new entrants to the economy are having an even tougher time getting a home — in fact, homeownership has dropped an astonishing 8% since 2004.

Ultralow Rates

As noted, ultralow rates make the rich richer because they can invest in assets with Fed-fostered high rates of return. Americans without the resources or skills necessary to invest in financial assets or wait for house-price appreciation still need safe places to put scarce funds to save for unanticipated events and plan for the future.

A new study from the Council of Economic Advisers shows the distributional benefit of a reasonable return from safe stores of value such as bank deposits. Without it, poor people get still poorer because they must wait a long, long time before having the resources for anything other than short-term consumption or emergencies. So much for wealth accumulation.

The Fed is now poised to lift rates 25 basis points — action some attribute to political pressure following the election's stunning results. The Fed might well have done so anyway, but it doesn't much matter from an income-inequality perspective. So few basis points so late in a tepid recovery will make little difference given recent increases in inflation and reductions in the value of the dollar.

New Regulations

The post-crisis regulatory framework has cumulative effects not only on bank structure and profitability, but also on how Fed-set asset and funding prices define the nation's economic winners and losers. On Friday, Mr. Trump said so, pointing in particular to how new rules adversely affect credit not for wealthy people such as himself, but for less wealthy, "good" people trying to start or expand businesses.

Banks perform several important financial-market functions, but the most critical of these is intermediation — translating funds into credit so that savings turn into loans that then accelerate growth. Monetary policy is premised on banks providing the transmission fluid for the gears of this engine of economic prosperity. Rates set by a central bank are supposed to move without friction from savers sending or withdrawing funds to banks making or curtailing loans. Large central-bank portfolios and ultralow rates break this engine when policy sets prices without resulting in sustained productivity. But just as stifling are new rules that make it increasingly difficult for private-sector resources to promote credit formation and economic growth.

The Fed has promised to consider the cumulative impact of its reformed regulatory rulebook once every page in it is complete and the markets learn to live under it. But the effects of regulation are felt on a faster schedule. A brand-new study by the Office of Financial Research confirms what every banker and his or her return-hungry investors already know: The merciless markets price in regulatory costs not long after the ink on a new rule is dry.

Perhaps President-elect Trump and his Republican Congress will simply bypass the Fed and foster economic recovery through expansionary fiscal policy — this is clearly the happy forecast buoying global equity prices. Any such rising tide will indeed lift all of the proverbial boats, but to what shore and upon how many rocks? Perhaps in time nonbanks will take on enough power in U.S. financial intermediation and liquidity creation that we can dispense with banks for all but an old-fashioned checkbook. Perhaps, but perhaps is not now. Now is a time of haphazard financial-market restructuring based not on policy needs but on regulatory loopholes. Without quick corrections to the regulatory causes of adverse distributional impact, fiscal firepower could fizzle as fast as the Fed's unprecedented monetary-policy initiatives and financial markets could get still riskier.

The Fed still has time has to make these corrections before it is targeted by the Trump administration. If the central bank fails to right the ship quickly, the consequences could make voters even angrier.

Karen Shaw Petrou is managing partner of Federal Financial Analytics.