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Introduction
The Federal Open Market Committee (FOMC) is often portrayed as a neutral body working tirelessly to maintain economic stability. With their meeting last week (31st July) where they declared that they’re holding the rates steady for now and said “rate cut could happen as soon as next meeting”, the impact of those decisions became evident after the fact with the stock markets losing nearly $3 trillion as fears of a recession grow. Clearly, the FOMC has a lot of power but why and how did this happen in the first place?
A deeper examination reveals a more complex and troubling reality. This article aims to provide a comprehensive understanding of the FOMC's operations, its historical actions, and the true nature of its influence on the U.S. economy and global financial systems.
The Origins of the Federal Reserve
The Federal Reserve was created in 1913 in response to a series of financial panics. However, its creation was shrouded in controversy:
The Federal Reserve Act was drafted in secret by bank representatives at Jekyll Island, Georgia, in 1910. This clandestine meeting, attended by some of the most powerful bankers of the time, laid the groundwork for a central banking system that would significantly alter the American financial landscape.
The Act was pushed through Congress during the Christmas holiday season when many legislators were absent. This timing raised suspicions about the intentions behind the Act and the haste with which it was passed.
It effectively privatized the nation's money supply, giving significant power to private bankers. This shift in control over the monetary system from the government to a quasi-private entity has been a source of controversy and criticism ever since.
Structure and Composition: A Facade of Public Interest
While the Fed is often referred to as a government agency, its structure tells a different story:
The 12 Federal Reserve Banks are privately owned institutions, operating mostly independently from direct government control. They are not funded through congressional appropriations but through interest on government securities and fees for services provided to banks. This unique structure blurs the line between public and private interests.
Member banks hold stock in their regional Federal Reserve Bank, which pays dividends, creating a financial incentive for participation. This stock is different from typical corporate stock in that it cannot be traded, sold, or pledged as collateral. However, the dividend payments create a direct financial benefit for member banks, potentially aligning their interests with those of the Federal Reserve.
Member banks elect six of the nine directors for each regional Fed bank, giving private banking interests significant influence over leadership. The Board of Governors appoints the other three directors, ostensibly to represent the public interest. However, critics argue that this structure gives disproportionate power to private banking interests in shaping monetary policy.
This structure allows private banking interests to influence the selection of Reserve Bank presidents, who participate in FOMC meetings and decisions. These presidents are not subject to the same public accountability measures as government appointees, raising questions about democratic legitimacy in shaping economic policy. The Reserve Bank presidents, despite their influence on national monetary policy, are not appointed by the President or confirmed by the Senate, unlike other officials with comparable power.
The FOMC's Extraordinary Powers
The FOMC's ability to set interest rates and control the money supply gives it unprecedented power over the economy:
Interest Rate Manipulation: By adjusting the federal funds rate, the FOMC influences everything from mortgage rates to the value of the dollar, impacting economic activity, borrowing, spending, and inflation. When the FOMC lowers interest rates, it becomes cheaper for banks to borrow money, which can lead to lower interest rates for consumers and businesses, stimulating economic activity. Conversely, when the FOMC raises rates, borrowing becomes more expensive, which can slow economic growth but help control inflation.
Money Creation: Through open market operations, the Fed can create money by purchasing government securities, dramatically increasing the money supply through quantitative easing. When the Fed buys government securities from banks or other financial institutions, it credits their accounts with newly created electronic money. This process can dramatically increase the money supply, potentially stimulating the economy but also raising concerns about inflation and currency devaluation.
Economic Forecasting: The Fed's economic projections often become self-fulfilling prophecies, shaping market sentiment and economic outcomes. When the Fed releases its economic outlook, investors, businesses, and consumers often adjust their behaviour in anticipation of the projected economic conditions. This can create a feedback loop where the Fed's predictions influence economic behaviour, which in turn validates the predictions.
Regulatory Authority: The Fed has broad supervisory powers over banks, allowing it to shape the financial landscape through capital requirements, stress tests, and merger approvals. This regulatory power extends beyond just monetary policy, giving the Fed significant influence over the structure and behavior of the financial industry. Critics argue that this concentration of power in one institution creates potential conflicts of interest, especially given the Fed's close ties to the banking industry.
Historical Evidence of Fed-Induced Recessions
The Fed has a long history of inducing recessions, often under the guise of fighting inflation:
The Great Depression (1929-1939): The Fed's actions (and inactions) played a significant role in turning a recession into the Great Depression. Following the stock market crash of 1929, the Fed failed to act as a lender of last resort, allowing thousands of banks to fail. It also pursued a contractionary monetary policy, reducing the money supply by nearly a third between 1929 and 1933. These decisions dramatically worsened the economic downturn, leading to widespread unemployment and economic hardship that lasted for a decade.
Roosevelt Recession (1937-1938): This downturn was largely caused by the Fed's decision to double reserve requirements between 1936 and 1937. This action, meant to give the Fed more control over an expanding money supply, instead led to a sharp contraction in the money supply and a subsequent recession.
Eisenhower Recession (1957-1958): The Fed's aggressive interest rate hikes in 1955-1957 to combat inflation directly led to this recession. The federal funds rate was raised from 1.79% in 1955 to 3.11% in 1957, triggering an economic contraction.
The Volker Double-Dip Recession (1908-1982): Fed Chairman Paul Volcker deliberately raised interest rates, causing unemployment to soar to 10.8%. This aggressive monetary tightening was aimed at combating high inflation but came at a significant cost to employment and economic growth.
The 1990-1991 Recession: Aggressive interest rate hikes in 1989 contributed to an economic downturn. The Fed's attempt to preemptively control inflation led to a contraction in economic activity and a rise in unemployment.
The 2001 Recession: Multiple rate increases between June 1999 and May 2000 contributed to the dot-com bubble burst. The Fed's tightening policy, aimed at cooling what was perceived as an overheating economy, played a role in precipitating the collapse of the tech bubble.
The 2008 Financial Crisis: While not directly caused by the Fed, its policies of keeping interest rates low and failing to adequately regulate the housing market contributed to the crisis. The Fed's monetary policy in the years leading up to the crisis created an environment conducive to excessive risk-taking and the formation of asset bubbles.
The 2020 COVID-19 Recession: While primarily caused by the pandemic, the Fed's subsequent actions, including massive quantitative easing, have raised concerns about future economic instability. The unprecedented scale of monetary intervention has led to debates about potential long-term consequences, including inflation risks and market distortions.
Federal Reserve Quotes Acknowledging Their Role in Recessions
If you think these are all just cherry-picked data points, here is an entire section of members of the Federal Reserve admitting their part in the recessions that they’ve caused.
Regarding the Great Depression: Ben Bernanke, in a speech for Milton Friedman's 90th birthday in 2002, said: "I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again."
On the 1970s Stagflation: Former Fed Chairman Arthur Burns, in his 1979 lecture "The Anguish of Central Banking," admitted: "...the Federal Reserve System had the power to abort the inflation at its incipient stage fifteen years ago or at any later point, and it has the power to end it today. At any time within that period, it could have restricted the money supply and created sufficient strains in financial and industrial markets to terminate inflation with little delay."
Regarding the 2008 Financial Crisis: Janet Yellen, in a 2010 presentation, stated: "For our part, the Federal Reserve failed to recognize the full extent of the risks and their potential to cause catastrophic consequences for the economy."
On the Volcker Recession (1980-1982): Paul Volcker himself, in his 2018 memoir "Keeping At It," wrote: "I was fully aware that there would be pain involved, but felt we had little choice if we wanted to break the inflation psychology."
Regarding the Fed's role in economic cycles generally: Former Fed Chairman William McChesney Martin famously said in 1955: "The Federal Reserve...is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up."
These quotes demonstrate that, at various points in history, Fed officials have recognized the significant impact of their policies on the economy, including their role in causing or exacerbating recessions. However, it's worth noting that these admissions often come years or even decades after the events in question, when the officials are no longer in a position to directly influence policy or face any repercussions due to it.
The Fed's Alignment with Private Interests
Several factors indicate that the Fed often acts in the interest of private banks rather than the general public:
Bailouts: During the 2008 financial crisis, the Fed provided trillions in secret emergency loans to banks, raising questions about priorities and moral hazard. These loans, made through various emergency lending facilities, were not fully disclosed to the public until years later, and only after significant pressure from Congress and the media. The scale and secrecy of these bailouts raised questions about the Fed's priorities and its willingness to protect banks at the expense of taxpayers.
Regulatory Capture: The "revolving door" between the Fed and the private sector can lead to policies favouring bank profitability over financial stability or consumer protection. Many Fed officials come from the banking industry and return to it after their tenure, creating potential conflicts of interest. This phenomenon can result in a regulatory environment that prioritizes bank interests over public interests.
Profit Motive: As profit-making institutions, Federal Reserve Banks may be incentivized to keep interest rates higher than necessary to increase income. While excess earnings are remitted to the U.S. Treasury, the profit-making nature of the Fed can potentially conflict with its regulatory and monetary policy mandates.
Lack of Transparency: The Fed has historically resisted full audits and disclosure of its operations, fueling suspicions about whose interests it serves. While the Fed argues that full transparency could undermine its effectiveness by subjecting it to short-term political pressures, critics contend that this lack of transparency shields it from necessary public scrutiny.
Uneven Impact of Policies: Fed policies often benefit asset holders while negatively impacting wage earners, contributing to growing wealth inequality. Low interest rates and quantitative easing tend to inflate asset prices, benefiting those who own stocks and real estate, while potentially leading to lower returns on savings accounts and fixed-income investments, which disproportionately affects middle-class and lower-income individuals.
The Discount Window and Quantitative Easing
The Fed's discount window and quantitative easing programs have been criticized for:
Providing cheap loans to banks, essentially subsidizing private profits. Banks can borrow at low rates from the discount window and then lend at higher rates, potentially creating a form of arbitrage.
Lack of transparency in operations. Details of borrowing from the discount window are often kept secret, limiting public oversight of these operations.
Enabling moral hazard by providing a safety net for risky behaviour. The availability of emergency lending facilities may encourage banks to take on excessive risks, knowing they have a backstop.
Exacerbating wealth inequality by inflating asset prices. QE programs have driven up the prices of stocks, bonds, and real estate, primarily benefiting those who already own such assets.
Sustaining zombie companies, potentially hampering economic dynamism. By keeping interest rates low and providing ample liquidity, QE has allowed unprofitable firms to continue operating, tying up resources that could be more productively used elsewhere.
Creating uncertain long-term consequences due to unprecedented money creation. The full impact of these policies on inflation, market stability, and economic growth may not be fully understood for years or even decades.
Constitutional Concerns and Lack of Accountability
The Fed's structure and operations raise significant constitutional questions:
Unelected officials (regional bank presidents) have significant power in monetary policy decisions, potentially violating the Appointments Clause of the Constitution. This arrangement appears to conflict with the requirement that principal officers of the United States be appointed by the President and confirmed by the Senate.
The Fed's ability to create money and set interest rates gives it enormous power with limited direct accountability to voters. Unlike elected officials who can be voted out of office if their policies are unpopular, Fed officials are insulated from direct public accountability.
Attempts to audit the Fed or increase Congressional oversight have been consistently resisted, fueling suspicions about potential conflicts of interest. The Fed has argued that increased oversight could compromise its independence and effectiveness, but critics contend that this resistance to scrutiny is more about protecting the Fed's power and its relationships with private banks.
The Fed's Role in Economic Inequality
Fed policies have contributed to growing economic inequality by:
Disproportionately benefiting those with access to cheap credit. Low interest rates allow wealthy individuals and large corporations to borrow money at very low cost and invest it in higher-yielding assets, an opportunity less available to average citizens.
Inflating asset prices, primarily benefiting the wealthy. QE has driven up the prices of stocks, bonds, and real estate, assets predominantly owned by wealthier segments of society.
Prioritizing inflation control over wage growth, often curtailing wage increases for workers. The Fed has historically raised interest rates at the first signs of wage growth, fearing inflationary pressures, even when corporate profits were high.
The World's Most Powerful Financial Institution
The FOMC's influence extends globally, affecting traditional equities and cryptocurrencies:
Global Market Maker:
Dollar dominance impacts global trade and international markets. FOMC decisions directly affect foreign exchange rates and international debt markets.
Sets the tone for global monetary policy, influencing other central banks. When the FOMC shifts its stance, many other central banks often follow suit.
Decisions on quantitative easing or tightening affect global liquidity, impacting emerging markets and speculative assets, including cryptocurrencies.
Impact on Equity Markets:
Interest rate sensitivity affects equity valuations. Lower rates often lead to higher equity valuations as investors seek higher returns.
Drives sector rotations based on policy changes. Different sectors react differently to FOMC policies, leading to significant market movements.
Causes market volatility around FOMC meetings and announcements. Traders and algorithms parse every word for clues about future policy directions.
Cryptocurrency Market Influence:
Affects liquidity conditions in crypto markets. Expansionary policies can lead to increased investment in crypto assets.
Impacts overall market risk sentiment. FOMC actions can encourage or discourage risk-taking, affecting high-risk assets like cryptocurrencies.
Influences dollar strength, which often correlates inversely with crypto prices.
Shapes the inflation narrative, affecting Bitcoin's perceived value as a hedge against inflation.
The Power of Perception:
Forward guidance shapes market expectations. Even subtle language changes can cause significant market reactions.
The "dot plot" moves markets despite being non-binding and often inaccurate.
Public appearances by FOMC members can cause market volatility, with their comments scrutinized for hints about future policy directions.
Conclusion: Unparalleled Market Influence
The FOMC's role as the world's most powerful financial institution stems from its ability to shape market realities through both concrete actions and market expectations. This vast influence raises critical questions about the concentration of power in the hands of a small group of unelected officials.
As citizens and stakeholders in the economy (especially if you're American), we must demand:
Greater transparency in Fed operations and decision-making.
Reform of the Fed's structure to reduce the influence of private banking interests.
More robust Congressional oversight and regular, comprehensive audits.
A reevaluation of the Fed's mandate to ensure it truly serves the public interest.
Only through such measures can we hope to create a monetary policy framework that truly serves the needs of all Americans, not just the financial elite. The power to create and control money is too important to be left in the hands of an institution that has repeatedly demonstrated its alignment with private interests over public good.
Further Reading:
https://en.wikipedia.org/wiki/Criticism_of_the_Federal_Reserve
https://www.americanbanker.com/podcast/buy-the-people-why-everyone-loves-to-hate-the-fed
https://prospect.org/economy/2023-04-06-federal-reserve-independence-problem/
Some Historical Reflections on the Governance of the Federal Reserve by Michael D. Bordo
https://streetfins.com/what-history-tells-us-about-the-recent-fed-rate-cut/