Along with all the other COVID-related lowlights from 2020, investors will also recall 2020 as the year the Federal Reserve gave up their independence. In response to a growing COVID threat the Fed rolled out its entire 2008 laundry list of emergency loan programs, then teamed up with the Treasury Department to introduce more.
Call them red lines, lines in the sand, or the Rubicon, the Fed crossed them all. If you considered the difficulty of shrinking a $4 trillion balance sheet without raising rates, think about it at $7 trillion. The 2020 deficit was a record $3.1 trillion and the Fed financed most of it. With another $900 billion relief act underway, 2021 will likely see another staggering deficit and the Fed has made clear they will fund that as well.
The Value of Independence
The primary objective of the Federal Reserve is to keep inflation and employment stable. The more the Fed can conduct monetary policy based exclusively on economics rather than political forces, more credibility will accrue behind their policies. Credibility leads to conditions of trust, where mere words from economic policymakers can impact inflationary expectations. Self-reinforced independence also limits any inclination to publicly opine on matters outside their responsibility.
It’s Not the First Time
From 1942 to 1951, the Federal Reserve was far more accountable to elected officials, and far more removed from private financial interests, primarily due to the costs associated with fighting World War II. As the Fed would later describe the division of duties, the amount of government spending was properly determined by Congress, it was the Treasury’s responsibility to determine the rate of interest it would pay to borrow and the Fed’s duty was to purchase government securities. In short, the Fed did as instructed. It shouldn’t surprise then that inflation from 1941 to 1952 averaged 5.9% annually.
What it Means Now
Reduced independence is reflected in Fed leadership taking a more expansive view of their mission, commenting on climate change, racial equity, income inequality and other social issues that monetary policy is wholly ill-suited to address. Fiscal and social policy are matters best left to democratically elected leaders and their institutions to set the nation’s agenda. As the Fed wades into these waters they will find themselves buffeted by one side or the other. Even now, some officials want the Fed to do more, viewing the attention given to social matters as but a first step. Others have worked to restrict the Fed to ensure the role it played during the pandemic does not outlast the crisis.
Fixed income investors must consider more than economic considerations to determine the path of interest rates. The Fed has made clear rates will stay low through 2023 despite expectations that 2021 will see 4% GDP growth. Why else to keep rates low but for the massive level of Treasury borrowings that must be serviced now and into the foreseeable future. At some future point, we will face the bill for all this largess.
Once upon a time the Federal Reserve was an institution that knew the limits of its abilities, making policy based on economic data and staying above the daily back and forth of politics. No longer.