A Fed in Crisis

The next Fed chair must keep inflation under control, a financial crash at bay and employment at normal levels.

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The most contentious Fed race in history just got a whole lot more boring.

Over the weekend, Lawrence Summers withdrew his name from consideration to be the next Federal Reserve chair. Summers made the right decision. His confirmation hearing was bound to be a circus, leaving the most powerful economic post in the world in limbo.

The next in line, Janet Yellen, is seen as far less partisan and more predictable than Summers. If nominated, her confirmation likely will be filibustered too, because that's what politicians in the minority do. But it will be far less messy and unsettling for markets. Frankly, there's just less raw material to work with.

If only the outlook for the Fed was equally snooze-worthy. The Fed is facing huge – if not insurmountable – challenges over the next few years. It's not just a morale crisis, though a survey earlier this summer revealed Fed staff are afraid to speak out, distrust their bosses, and feel isolated.

[See a collection of political cartoons on the economy.]

The Fed is facing economic and capacity crises. The so-called "taper" is one part of the story. The decision how and when to stop pumping $85 billion into the economy each month has haunted the last half-a-dozen Federal Open Market Committee meetings. On Wednesday, the Fed punted the taper decision, delaying the inevitable but not eliminating it. Eventually the economy will have to stand on its own two feet without Fed support. The next Fed chair will get the privilege of sorting out when that happens.

 

But the bigger story – the one that everyone seems to be missing – is how the responsibilities of the Fed have exponentially grown under the Dodd-Frank financial reform law. The Fed has been tasked with writing and implementing many of Dodd-Frank's 398 rules, including setting financial sector concentration limits, real estate appraisal models and margin and capital requirements for swap dealers.

Even more significant, the Dodd-Frank Act made the Federal Reserve the prime supervisor and regulator of financial institutions deemed systemically important. The Fed is the "cop on the beat" against the next financial crisis, supervising the biggest banks' adherence to a laundry list of new, heightened prudential standards including counter-party exposure limits, liquidity and capital requirements and risk management practices. The Fed is also administering annual stress tests to find out if these firms have sufficient capital to withstand an economic downturn more serious than 2008.

[Read the U.S. News Debate: Has the Federal Reserve Overstepped its Mandate?]

Adequately supervising these firms will take tremendous resources and expertise the Fed currently does not have. The 2013 operating budget of the Fed was up 6.5 percent year-over-year, but this is hardly enough to compensate for the massive increase in the responsibilities. The Federal Reserve has roughly a $3.5 billion budget, whereas the 50 largest U.S. banks hold $15 trillion in assets. This is David versus Goliath.

For the first time in history, the Fed also has been tasked with regulating non-banks if they are deemed systemically important, as GE Capital and AIG have been. The balance sheets and capital structures of nonbanks are radically different from each other and the banks the Fed has historically regulated. An entirely new regulatory approach will be required for these companies.

All the while the Fed still has its day-job: pursuing the dual mandate. On this, the Fed too is hitting a brick wall. GDP growth remains stuck at or below 2 percent. More than 11 million Americans are still unemployed. The Fed has engaged in monetary stimulus to promote economic growth and job creation, but can only do so much when the Obama administration and Congress seem to have abdicated fiscal responsibility.

[See a collection of political cartoons on Congress.]

During the height of the crisis, the administration pushed through two massive reforms, Obamacare and the Dodd-Frank Act, both of which have resulted in considerable uncertainty and have raised the cost of doing business. The National Federation of Independent Businesses reports that regulation, red tape and taxes are the biggest problems small businesses face – even more than poor economic growth.

As icing on the cake, there's incredible uncertainty about the fiscal direction of our country as we enter into another debt limit fight this fall. The last debt limit fight in August 2011 resulted in a massive increase in taxes on American families and small businesses; hardly a recipe for growth.

The next Fed chair faces a tall order. He or she will be tasked to keep inflation under control, a financial crisis at bay, and employment at normal levels. While the confirmation process was easier by events over the weekend, the job description keeps getting harder.

Abby McCloskey is program director of Economic Policy at the American Enterprise Institute. She was a staffer for Senator Richard Shelby during financial reform and director of research at the Financial Services Roundtable.

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