Congress is partying like its 1982, aiming bill after bill at the Fed. Lawmakers grill Fed head Janet Yellen over her political leanings and social calendar, threatening her with a leash. Audit monetary policy! Set interest rates with rules! Yet, in their politicized battle against Fed politicization, they overlook an arm of the Fed that is politicized and opaque: the merry band of stress-testers, who control whether 31 American bank holding companies can pay dividends or buy back shares. So while this is a good time to thank gridlock for preventing Congress from meddling with monetary policy and spooking stocks in the process, it’s also a time to consider unseen risks at 20th and Constitution Ave.
As always with all things political and market-related, let’s set partisanship and ideology aside—bias blinds, and both parties are capable of annoying markets. Stocks don’t care who writes a bill or who signs it. They care how policies impact property rights and commerce overall. Stocks also care about surprising monetary policy mistakes, so it’s reasonable to assume they wouldn’t like new laws inviting error.
Inviting mistakes is what the Fed reform bills currently circulating Congress would probably do. Titles like Federal Reserve Transparency Act of 2015 sound nice—everyone loves transparency!—but both the House and Senate versions would subject monetary policy and the Fed’s balance sheet to Congressional review. The more influence politicians have over monetary policy, the less likely Fed people are to do important things like hike rates to fight inflation. Consider then-Senate Majority Leader Robert Byrd’s (D-WV) indictment of the Fed’s very necessary tightening in October 1979: “Attempting to control inflation or protect the dollar by throwing legions of people out of work and shutting down shifts in our factories and mines is a hopeless policy.”[i] This mentality is timeless and not unique to the late former Senator. Politicians have a vested interest in a fast-growing economy bringing lots of jobs for them to brag about. Many (incorrectly) view rate hikes as job-killing poison. If they have influence over interest rates, price stability probably isn’t top-of-mind.[ii]
Gridlock will probably kill this, just as it killed the Federal Reserve Accountability and Transparency Act of 2014, which would have forced the FOMC to set interest rates according to the Taylor Rule, a mathematical formula based on inflation, potential output, real output and the Fed’s inflation target.[iii] That is probably good, because there is ample evidence the Taylor Rule doesn’t work great when conditions are extreme.[iv] The bill is potentially on its way back but still stands little chance. Gridlock will probably also kill H.R.1154, called FFOCUS, which would replace the Fed’s dual mandate with a directive to focus on stable prices—fine, but window dressing.[v] Also likely to die is H.R.113, The Federal Reserve Accountability and Transparency Act of 2015, which asks the Fed to use less jargon, do a cost/benefit analysis of all proposed regulations and communicate more about the metrics in its quantitative stress tests. (It misses the elephant in the room, the qualitative stress tests.)
None of this is new, and I’m tempted to award them half a point for being less meddlesome than the rambunctious bunch on Capitol Hill in 1982. That group introduced bills that would have installed the Treasury Secretary on the FOMC[vi] or Board of Governors, capped interest rates at inflation plus three percentage points, subjected monetary policy to Congressional audit (sound familiar?) and given Congress veto power over any monetary policy decisions that moved rates outside the prior year’s range.[vii] All terrible! And thankfully dead. But they illustrate an annoying fact: Congress loves monkeying with things it doesn’t understand.
Which brings me to the stress tests, specifically the Comprehensive Capital Analysis and Review (CCAR). CCAR isn’t the “can banks survive a crisis?” test. It’s the “do banks have enough capital and meet our ever-changing arbitrary conditions to return capital to shareholders” test outlined in Dodd-Frank. The Fed seems to fail at least one bank annually for reasons no one understands and officials choose not to communicate. These tests are a moving target and have apparently supplanted traditional reserve requirements and international capital standards as the Fed’s preferred regulatory tool. Banks can’t mathematically predict what they need to do in order to comply because the tests are not mathematically based. The Fed can flunk banks based on its opinions and mood. As a result, banks are hoarding cash and spending gazillions on compliance, both potentially hampering traditional banking functions, like lending.
One would think a Congress obsessed with transparency would see this, but Congress is largely anti-bank. Bank angst gave us Dodd-Frank and CCAR, misguided attempts to prevent a repeat of 2008.[viii] CCAR puts the bank-bashing mentality at the heart of Fed regulatory policy, effectively politicizing the institution—and few see it. Congress seems delighted to let an all-powerful committee operating behind closed doors control banks’ business models, considering it just desserts for 2008’s bailouts and being too big to fail. People are sympathetic to this, but it’s incongruent with other bailed-out, supposedly too big to fail companies. GM was bailed out, too, because the consequences of it failing, we were told, were too dire. Which we have been told is basically the definition of “too big to fail.”[ix] And the feds lost money on the automaker bailouts (unlike the bank bailouts, which turned a profit)—but GM didn’t have to pass a stress test before announcing a share buyback program this week. Lockheed was bailed out in 1971 because its failure would have wiped out jobs across California, but its capital plans aren’t rubberstamped. There is a two-speed system for banks, and it is mostly political. Banks aren’t the only American companies who get government assistance in times of crisis. They’re just the institutions everyone loves to hate. Largely always have been.[x]
None of this should hit stocks in the foreseeable future—CCAR is widely known and lacks scale, at least for now. In the far future, who knows: It gives the Fed a framework to add destructive rules a la mark-to-market accounting for illiquid assets or something equally pro-cyclical—frothing bank balance sheets in good times and crushing them in bad times. Ideally Fed deliberations over this would happen in sunlight, but the stress tests give them a mechanism for applying tough, harmful rules with no public comment. They can just add it to the test. This isn’t likely any time soon, but it’s a risk to keep in mind.
In the meantime, though, three cheers for gridlock. Whatever problems the Fed has, and there are many, adding politicization and “Congressional oversight” to monetary policy won’t fix them—it’ll make them worse. The absence of this negative is a positive outweighing the Fed’s widely known arbitrary tendencies in the regulatory arena.
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[i] Lifted, with gratitude, from “The Reform of October 1979: How It Happened and Why,” by David E. Lindsey, Athanasios Orphanides and Robert H. Rasche, published by the St. Louis Fed in March 2005 and available here.
[ii] You can probably also forget about anything sensible coming from balance sheet auditing, considering the Senate bill’s lead sponsor has not demonstrated the ability to read the Fed’s balance sheet correctly. For the record, at the time of that speech, the Fed did not have $57 billion in assets and $4.5 trillion in liabilities. They had about $4.6 trillion in assets, $4.5 trillion in liabilities and $57 billion in total capital (assets and liabilities both rounded to the nearest 100 billion). I suspect he is not alone, as Congress tends not to attract people who can read balance sheets.
[iv] The paper in Note 1 has some good nuggets on the Taylor Rule and the super-high inflation in the late 1970s. On page 215, the authors observe: “The strategy if exact adherence to this rule would not have delivered much better outcomes than the policy in place before the reforms of October. And adherence after October 1979 would have prevented the tightening necessary for controlling inflation.”
[v] The dual mandate is a silly thing, created in 1978 and based on the antiquated Philips Curve theory about inflation and unemployment. Milton Friedman debunked it sometime in the 1960s.
[vii] See the preceding footnote.
[ix] Worth noting here that institution size wasn’t really a driver of 2008’s financial crisis.
[x] Look up the history of Glass-Steagall for more on this. It all started with some extremely loud bank-bashing from a guy named Ferdinand Pecora, who basically goaded Congress into walling off retail and investment banks.