Editor's note: The following is adapted from a speech the author gave in November.
As markets have focused monomaniacally on the Federal Market Open Committee, the Federal Reserve System held two little-noticed conferences recently in which every important senior Fed official participated because of the gravity of the events' topics. Together, the two highly relevant sessions – one focused on financial stability and the other on monetary policy – prompt this provocative question: Does the Fed even matter?
One conference looked at whether the Fed's vaunted macroprudential regulation – a bedrock reform designed to avert crises – is functional. The other targeted an equally critical and even more immediate concern: whether the Fed can still transmit its monetary policy edicts because financial markets have changed so profoundly so fast. Both of these questions arise because big commercial banks just aren't what they used to be, with nonbanks increasingly taking over market share. The latest global data show systemic-sized nonbanks now control $14.2 trillion in U.S. assets – and that's a walloping underestimate because it leaves out the government-sponsored enterprises and critical nonbank functions such as the payment system.
If the Fed can't ensure financial stability or set monetary policy, then what good is it? We need a functional Fed, but that means the Fed must quickly reckon with the new financial market created in large part by its own rules.
Any suggestion that new rules have reshaped the U.S. financial market is usually taken as a backdoor plea for regulatory lenience. If, though, the Fed is finding that the new market confounds its ability to constrain risk or secure growth, far more urgent questions must be asked. Do some rules so fundamentally redefine the Fed's policy premises that those rules should be rethought? Does the new market warrant changes to how the Fed conducts itself? Are both rules changes and reform of the Fed necessary? I think so and here's why.
Monetary Policy Is Off the Rails
U.S. monetary policy is premised on the essential role of banks as the channels through which the Fed's will is exerted. The Fed has long relied on interest rates and reserves, but each of these tools assumes that the cost of funds depends on banks and that the reserves banks post with the central bank affect how much money is available for loans and thus to promote economic growth.
However, banks are no longer the prime repositories of the nation's money, meaning that trying to change how the market expends liquidity by altering bank incentives is an increasingly blunt Fed tool. A recent Federal Reserve Bank of Atlanta conference took a hard look at this, with an important paper there on "shadow liabilities" demonstrating that an array of nonbank liabilities – including money market funds, mutual funds and repos – have become major market drivers. This and other papers also laid out how the widespread use of asset securitization profoundly changes intermediation channels. Banks do not need to rely on deposits to fund loans and instead can just offload assets to the secondary market or bond funds. Nonbanks now also originate trillions of dollars of credit. So the link between the fed funds rate and the price of credit has grown increasingly tenuous.
Several new studies, including those presented at the Fed Board's conference and a study recently released by the Federal Reserve Bank of Boston, also demonstrate that reserve balances at the Federal Reserve are significantly distorted. Just before the crisis, banks held $2 billion in excess reserves at the Fed; now they hold $2.5 trillion – not a small change and one with profound monetary-policy impact.
Theory would have it that macroeconomic growth would drain excess reserves because demand for credit would grow, resulting in a higher return than what banks achieve by storing funds with the central bank. However, even as growth has improved, excess reserves have grown at an even faster pace. One reason for this is the combined cost of new capital and liquidity requirements, which not only create negative feedback loops from a safety-and-soundness perspective, but also distort incentives for holding excess reserves versus economically-productive assets. Banks have thus not been able to reallocate reserves to promote growth. This is one reason that economic growth has proved so anemic despite trillions in unprecedented accommodative policy.
Market Shifts Are Destabilizing
The Fed's monetary-policy problems translate immediately into its macroprudential worries. If nonbanks now can drive rates and originate credit with little regard to FOMC action, while avoiding microprudential capital and liquidity rules, markets are irresistibly drawn to boom-bust cycles. This was of course the procyclicality that preceded the 2008 cataclysm, with much of the fevered demand for high-risk subprime mortgage-backed securities coming from nonbanks (GSEs very much included). Now, we are seeing these same procyclical trends in other credit markets where yield-chasing may be more desperate than it was eight years ago. Look at syndicated loans where banks thought they could hand off the merchandise, commercial real estate where nonbanks play a huge role, and subprime auto finance where investors have seemingly insatiable demand.
Rebalancing Rules May Be the Answer
Can the Fed curb this high-risk enthusiasm? An important "tabletop" exercise released at the macroprudential conference proves it can't. So far, the only macroprudential tool the Fed has put in place is stress tests for big banks, but the tabletop exercise shows these have little impact because banks no longer drive the pricing of liabilities or the availability of assets strongly enough to redirect the market.
The tabletop exercise also looked at whether monetary policy could be used in lieu of macroprudential regulation as a countercyclical force if macroprudential rules don't work. But it found that monetary policy also can't transmit the Fed's edicts.
In short, neither monetary policy nor macroprudential rules matters. Is this because some fundamental economic principle now stymies central banks both as economic and financial-market safeguards? Looking at what's different between periods when both monetary policy and prudential rules worked and now – when they clearly don't – a critical variable is a lot of new rules applied only to banks. Taking those rules in concert with technology changes that empower nonbanks and the challenge is clear: Rebalance the rules or figure out a new way to secure stable growth and sound markets.
Karen Shaw Petrou is managing partner of Federal Financial Analytics.