Macroprudential Regulation: A New Way the Fed Can Fail

Evidently, Janet Yellen has gone rogue. I know, I know. How controversial can a 70-year-old "unarmed economist from Brooklyn," as one of her neighbors recently described her in The Wall Street Journal, really be?[i] I mean, aside from having an annoying, doughnut-bellied security detail that bugs the heck out of her HOA?[ii] And if we're talking everyday life, well, my guess is, not very-she seems a rather mild bird. But in central banking land-quite decidedly a plane of existence thrice removed from reality-she's making waves. Just three days after the Bank for International Settlements-the bank of central banks-released a convoluted report urging central bankers to hike rates in the name of financial stability, Yellen told the IMF she thinks central banks have no business using monetary policy to pop bubbles. Hear, hear! But before free-marketeers could even think of fist-pumping, she showed her true feathers: Macroprudential regulatory changes, she clarified, were far better. Sigh. As if the world needs one more central bank thinking it's above reproach and knows-better than every other human on earth-when bubbles are forming and how best to pop them. Sorry, history shows otherwise. If central bankers got over their superiority complex and just went back to boring old basics, economies and markets would be far better off.

For one, whether we're talking marcoprudentual regulation (let's just call it "macropru") or interest rates as the weapon of choice, there is a logical flaw in assuming central bankers can and should be bubble slayers. Namely, there is no evidence they're any good at seeing bubbles, never mind discerning appropriate ways to deflate them. Alan Greenspan's infamous "irrational exuberance" line came in December 1996, well before the tech bubble was, well, a bubble. Transcripts show no Fed member spied the housing bubble before it started bursting in early 2006. Last week, the Bank of England decided to let some air out of a housing bubble that doesn't even exist, capping the amount of new mortgages equivalent to 4.5 times (or more) the borrower's income at 15% of total originations. No, I don't think they believe this will magically incentivize more home construction in London, easing the supply constraint that's driving up prices. They're just confused.

But the larger fallacy is this: Central banks were never supposed to be bubble hunters or all-powerful economic policy overlords. The Federal Reserve Act of 1913 created the Fed to be lender of last resort for the nation's banks, with the aim of preventing full-on panics and 19^th century-style bank runs. That's it. The Banking Act of 1933 established the FOMC, giving them the power to control money supply growth. 1978's Humphrey-Hawkins Full Employment Act established the infamous dual mandate, forcing the Fed to pursue maximum employment and price stability (and consigning it to antiquated economic theory Milton Friedman had debunked a few years earlier).[iii] And that's basically it. The Fed is applying an extremely liberal interpretation of the their legislated power to prevent panics, adding to the risk of error. Preemptively pricking asset bubbles is decidedly outside the Fed's legal purview.

Now, I don't often say this, but Congress got that right. The Fed is politically independent, and that's good-the last thing we want is an administration-any administration, led by either party-being able to manipulate interest rates for political gain. Leave that one to proto-fascist states like Hungary. The Fed operates with minimal legislative oversight, and for simple monetary policy purposes, that's a good thing. But "simple monetary policy purposes" is the key here. The Fed was never intended to be an above-the-law super regulator. It just sort of ended up there, slowly absorbing various powers from the Office of the Comptroller of the Currency and Office of Thrift Supervision.

As a result, the Fed is a largely unchecked institution with regulatory powers. It basically gets to make laws without actually, you know, passing them. When FOMC members decide to give themselves a mandate to maintain financial stability, no one bats an eye-folks (wrongly) believe central bankers are the solution to all of an economy's ills. Because they're smart. With fancy degrees. So they must know things and be right. We mere mortals shouldn't question the wisdom of their self-imposed extraordinary powers.

This is dangerous. Look. These people aren't any wiser than most of the rest of us-and most of them don't have real-world experience. Rarely does someone who has spent decades in the ivory tower know the struggles of a small business owner in small-town America. Or a community banker. They know equations and theory, but theory isn't reality. Policies that work in text books, where models have controlled variables and no outside influences rarely work in the real world. The real world is messy. That's problem 1. Problem 2: When the Fed makes policy decisions, they do it behind closed doors. That robs folks of the opportunity to hear an open debate, call their congressperson, make public comments and slowly get used to whatever changes might be in the pipeline. Decisions are made in secret, sans public comment. Markets don't get the luxury of anticipating and pricing them in before they take effect. They happen in the blink of an eye, leaving the rest of us to adjust on the fly.

That's where regulatory risk comes from. Big, long-debated legislation gets all the headlines, like the Affordable Care Act, but those sorts of laws most often aren't market risks. Even if they alter America's structural backdrop somewhat, widely discussed legislation doesn't usually cause cyclical turning points. The phase-in period is too long. Markets have ample time to adapt, discover potential winners and losers and make adjustments. Congressional debate is an investor's friend. The real trouble comes when regulators write the rules. Whether that's Congress outsourcing Dodd-Frank to the Fed, the FASB following up Sarbanes-Oxley with the mark-to-market accounting rule or, in Europe, the ECB deciding for itself what rules to force on eurozone banks after the European Parliament rubberstamped it as regional banking regulator.

The Fed's macropru efforts are just another iteration of this risk. The more unchecked latitude the Fed has, the more room it has to write rules behind closed doors and then whack markets with them. Because what if they're wrong? What if they hike capital requirements when they don't need to and lop off an expansion five years too early? What if they make it too hard for small banks to compete, driving them out of business?

Go back to basics-go back to the letter of the law (heck, go back to 1913)-and none of this is an issue. The Fed becomes boring again. No one notices them. No superiority complex. Just a guess, but markets probably get more harmonious-that's just what happens when there are fewer interruptions and variables.

Will it happen? Probably not. Post 2008, there is the persistent belief central bankers are The Answer. Ben Bernanke hoodwinked folks into believing the Fed saved the day then, cementing their reputation. Even though Fed transcripts show otherwise, the narrative stuck. Until folks see the emperor has no clothes, we'll just have to live with this potential risk factor.

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[i] This is a rhetorical question.

[ii] This isn't a joke. I mean, it kind of is. But it's also real. Like, really real. No Hollywood screenwriter could dream up this tale of suburban angst and power-tripping. See for yourself.

[iii] This law is a piece of work. Only politicians could dream it up. In addition to the dual mandate, it orders the federal government to fix the "major national problem" of trade deficits, balance the budget, fix inflation, "meet the needs of private enterprise," and write a bunch of annual reports. You can read it here. It's a miracle of modern history that this monster was never enforced.