The Fed Is Biting Off More Than It Can Chew

Janet Yellen should get the Federal Reserve out of the business of trying to regulate everything.

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With the full Senate likely voting to confirm her nomination later this month, Janet Yellen is now poised to take over as chair of the Federal Reserve when current chairman Ben Bernanke's term expires on Jan. 31.

Unlike most regulators, the Fed chair shows up often enough on television screens and in newspapers to become familiar to Americans far removed from Washington, D.C. From the imposingly tall Paul Volcker to the large-spectacled Alan Greenspan to the current professorially bearded Ben Bernanke, Fed chairmen enjoy their 15 minutes of fame.

And yet, as significant a role as this person plays in the lives of everyday Americans, the duties of the central-banking wizard are largely shrouded in ambiguity. Given the rapid growth in the Fed's portfolio, the likelihood that the central bank is taking on more than it can handle and the possibility that it will be a source of — not a solution for — financial instability, it's time to look behind the curtain.

Some confusion stems from the fact that the job of the Fed chair has changed over the years, with missions ranging from providing services to banks, to regulating, to setting monetary policy. The latter, whereby the Fed attempts to keep prices stable and unemployment low, gets the most attention. That dual mission, which many believe to be hopelessly broad, sounds pretty impressive in theory, but has not worked well in practice.

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

To improve performance, the Fed has been testing some new tools, e.g., buying large quantities of mortgage-backed securities. It isn't clear whether this benefits the economy, but it leaves the incoming chair with a big challenge — figuring out what to do with all the mortgage bonds the central bank now has on its books and how to stop buying new ones without harming markets.

During the financial crisis, the Fed chair's role as crisis manager also cast him into the spotlight. Again, this job is actually not as glamorous as it sounds. It consisted of cooking up programs to use taxpayer money to rescue ailing firms or back up different pieces of the financial markets.

After the crisis abated, Bernanke donned a lobbying hat. He convinced Congress to expand the Fed's already substantial role as regulator to encompass more pieces of the financial system. The new Fed chair likely will keep lobbying for more power, since some pieces of the financial system, such as money market mutual funds, are still outside the Fed's regulatory grasp. But as this Mercatus Center chart shows, the Fed may have already bitten off more than it can chew in the regulatory oversight landscape.

The often-forgotten regulatory piece of the Fed chair's job was front and center at Yellen's Senate confirmation hearing last Thursday. The Fed oversees a range of entities, including certain banks, the bank holding companies in which most banks reside, savings-and-loan holding companies, companies that serve as the utility-like pipelines of the financial system and many large nonbank companies. The latter is an expanding group of firms identified by a council of regulators under the Dodd–Frank Wall Street Reform and Consumer Protection Act as likely causes of financial turmoil. This council has handed some insurance companies over to the Fed and may soon put large investment advisers that manage mutual funds under the Fed's control. These entities already have other regulators, but the Fed — not known for its humility — thinks it can do a better job.

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

The Fed also has a broader regulatory mandate to maintain financial stability and tamp down risk in the markets. To be candid, it doesn't really know how to achieve these objectives, but it experiments with different approaches. It is particularly enamored of a method that it learned from its friends in Europe, whereby the Fed can override private companies' sound decisions if they run afoul of the Fed's grand design for the whole financial system.

Undergirding the laws that put these responsibilities on the Fed's to-do list is a great deal of wishful thinking. The Fed cannot control the economy, the financial system or even the banks it regulates nearly as precisely as its defenders claim — and increasing its regulatory responsibilities over entities with which it is unfamiliar will further distract the central bank from its monetary policy mission. Because the Fed's missteps can have dramatic consequences for the economic well-being of average Americans, Congress should rethink the scope of the Fed's mission. For her part, Janet Yellen, if confirmed, ought to check the wishful thinking at the door and approach her new tasks with a deep appreciation for the limits of the institution she leads.

Hester Peirce is a senior research fellow with the Mercatus Center at George Mason University. She previously served as counsel on the Senate Banking Committee during the drafting of the Dodd-Frank Act.

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