How to fix the fed: the ineffectiveness of the U.S. central bank's credit policy.

• Author: Tatom, John A.

Congressman Jeb Hensarling (R-TX) introduced the Financial CHOICE Act to reform the Federal Reserve in late 2016 and is expected to resubmit it early in the new session of Congress. Its key monetary policy focus is on imposing a monetary rule on the operation of the Fed. This is a worthwhile effort, like its many other admirable features, but it does not address the Fed's asset powers or its new ability to pay excessive interest on reserves, which over the past eight years have allowed the Fed to inflate its balance sheet, and to do so without little effect on monetary aggregates. Just as the Fed caused the Great Recession by stagnant growth of its monetary base, its expanded powers since late 2008 allowed it to prolong the recession and stifle the recovery and expansion while appearing to provide explosive stimulus. The Fed focused on expanding its credit and expanding its lender-of-last-resort function while restraining the growth of monetary aggregates and bank credit. The Fed has not acted in such a counterproductive manner since October 1931, when it raised the discount rate in the midst of the Great Depression. Without a focus on money, adherence to an interest rate rule will not be effective in achieving low inflation and monetary stability.

The seeming paradox of U.S. monetary policy is that the Federal Reserve's ballooning balance sheet has been accompanied by recession, financial crisis, a tepid recovery, and restrained inflation, not evidence of historic monetary policy stimulus. The resolution of this puzzle is the shift of the Fed to a focus on its own credit creation, which it largely sterilized using sizeable above-market and questionable subsidies to banks for holding excess reserves, with the indirect result that money often has grown at a recessionary pace despite the explosion of Fed credit.

Fed assets are about five times larger now than the $894 billion registered at the end of 2007 when the recession began, rising $3.6 trillion since then. Until 2008, Fed actions that changed its credit supply (Reserve Bank Credit) also changed its monetary base, the base for the nation's money stock. Beginning in late 2008, however, the Fed was able to separate credit creation and money creation. Instead of a five-fold increase, the Fed's effective monetary base, the monetary base excluding bank excess reserves, rose only 86.4 percent, or at a 7.3 percent annual rate since the end of 2007, only slightly faster than the 7 percent rate over the previous thirty years. This is not the extremely inflationary pace suggested by many analysts who have focused on the huge increase in the Fed's balance sheet. But disturbingly, there have been episodes of unusually slow growth in the Fed's effective monetary base that explained the onset of recession, its depth and length, and the weak recovery.

The Fed separated the expansion of Fed credit from money by introducing relatively high, subsidized interest on excess reserves. This made it possible for the Fed to buy trillions of dollars of high-risk securities, including some $1.7 trillion of mortgage-backed securities, and to induce banks to hold the receipts from those sales as excess...