America’s Founding Fathers are having a very bad year. Their names sullied. Their likenesses defaced. The principles they pronounced attacked. Of greatest consequence, the institutions at the core of our republic are being tested.
Commentators tend to anthropomorphize the most prominent independent government institutions: the Roberts Court and the Powell Fed. The person atop is regularly glorified or vilified. Yet the institution matters more than the person. Liberal democracy relies on the strength and resilience of longstanding entities, especially when popular sentiment is running hot and circumstances are grave. People in positions of power are flawed, the Founders warned, so the institutions in our government must be robust, resilient and responsible. Our finest institutions are well-designed, rich in tradition and humble in orientation. They must defend themselves against unexpected shocks that can harm them and those they are charged to serve.
The Supreme Court is an independent institution that has long faced political and social scrutiny. Its decisions, however divided and divisive, are the unquestioned law of the land. The court’s doctrine of stare decisis (deference to precedent) and the lengthy appellate process serve as bulwarks. Its foundation is laid firmly in Article III of the Constitution. And its powers are restrained by the Constitution’s other six articles.
The Federal Reserve rests on less-settled ground, so its success and survival are less certain. America’s two prior experiments with an independent central bank failed. The Fed’s recent centennial celebration is only a mark of longevity, not a guarantee of permanence.
The Fed’s formal authority comes from a congressional statute. The real source of its power, however, is more diffuse and fleeting. Since Chairman Paul Volcker’s tenure (1979-87), the Fed has developed a strong institutional culture: an apolitical bearing, a resistance to whims, a durable record of ensuring price stability and a strong sense of collegiality and mission. Its successes—whipping inflation in the Volcker era, encouraging a productivity surge in the Greenspan era (1987-2006), responding with imagination and acuity to the financial crisis in the Bernanke era (2006-14)—have enhanced its power.
Yet the Fed’s recent errors are equally clear. It came into the past two major shocks as surprised and ill-prepared as the economy it oversees. The Fed missed the decadelong window between the 2008 crisis and this year’s pandemic to prepare and reform. Its policies are predicated on a typical business cycle. Yet unanticipated shocks put the Fed at far greater distance from its employment and inflation objectives than normal downturns do. The Fed needs a robust ex ante plan to mitigate economic harm from major shocks.
Beginning in 2011, the Fed made a big institutional bet on a benign forecast. It wagered that the long period of relative prosperity would continue without another shock. The global financial crisis of 2008 would be the great aberration to the Great Moderation; the long period of relatively stable output and inflation would continue uninterrupted.
As recently as this January, Fed leaders assured the public that even if the economy weakened significantly, the policy mix of the 2008 crisis—rate cuts, purchases of Treasurys and agency securities, and forward guidance—would ensure financial and economic stability.
Then the pandemic hit. The economy collapsed and financial market prices followed. The Fed was on the precipice of losing its hard-earned credibility and vaunted status. With few good options, it was compelled to double down. It made low interest rates lower and its big balance sheet bigger.
That wasn’t enough. The 2008 playbook of shock and awe had become too routine to provide sufficient stimulus this time. So the Fed crossed red lines that had stood for a century. It backstopped private corporate bonds and public municipal securities, including some with dodgy prospects.
In his address at last month’s Jackson Hole conference, Chairman Jerome Powell unveiled the conclusions of the Fed’s new policy regime: Inflation has been running too low for a decade. Monetary policy has long been too tight. The monetary spigot must be opened wider to get to a higher average inflation rate.
If the economy does well in coming quarters, I expect the Fed will expand significantly the scale, scope and duration of its asset purchases. If the economy weakens or financial markets fall, the Fed will do even more. This is what political scientists call path dependency. When an institution sticks to a path for so long, it finds its options limited, detours difficult and exits infeasible.
The Fed is on a one-way path to a larger role in our economy and government. On the current trajectory, the
Bank of Japan
might be the model for Fed policy: a large buyer of public stocks and an indistinguishable partner with fiscal authorities. The unimaginable can become the inevitable.
What has been the response to Fed flexing? Most on Wall Street are thrilled. They quite like stimulus for all seasons and all reasons. The Fed will buy assets others don’t and pay prices others won’t. Even if the central bank were to pull back its support for corporate and municipal bonds, traders believe it would step up again in a pinch.
Main Street is rightly more circumspect about the Fed’s largess. Interest-rate cuts have a much more direct and significant effect on the real economy than the latest Fed machinations do. But there is no room left to cut interest rates. And Main Street firms are receiving far less fiscal and monetary support than Wall Street.
Bipartisan majorities in Congress are praising the Fed’s expanded role. The Fed’s growing purchases of the government’s expanding debt lowers the costs of fiscal spending. Mr. Powell’s apolitical demeanor and relationship-building efforts with lawmakers have provided the institution with substantial leeway. But elected representatives can be fickle. If the last crisis is a guide, the recriminations will come once the panic recedes.
For now, the Fed sits atop the commanding heights of the economy—its growing authority unquestioned, its pride manifest. But over time, citizens in a constitutional system tend to grow wary of omnipotent institutions.
The Fed is exercising understandable but unprecedented power at an ahistorical moment. Without vigilance, it will risk morphing into a general-purpose government agency. America cannot afford to have its central bank lose its independence, gravitas and record of success. To paraphrase Ben Franklin on the institutional challenge: a central bank, if you can keep it.
Mr. Warsh, a former member of the Federal Reserve Board, is a distinguished visiting fellow in economics at Stanford University’s Hoover Institution.
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