by Mitch Kokai
Senior Political Analyst, John Locke Foundation
ONE OF THE KEY economic challenges for the next U.S. President will be to set a new course for the Federal Reserve. That’s a vital step in breaking out of the 2.2% “new normal” and achieving the 4% GDP growth needed to bring more workers into the labor force and lift middle-class incomes. The Fed should be independent, but it can’t remain the 800-pound gorilla in the economy and financial markets that it’s become.
By setting interest rates near zero and holding bond yields down, the Fed has been picking winners and losers, tilting the playing field toward big borrowers and against savers. The vast majority of new credit has been going to government and big corporate bond issuers (which qualify for superlow rates) at the expense of households and small businesses (which often don’t qualify).
While the Fed calls its policies accommodative, in practice they’re tight for most of the economy. The biggest borrowers get more credit than they need at cheaper interest rates than they require, while smaller, more productive (though riskier) borrowers are left out.
Labor productivity fell in the first quarter and had one of the weakest growth rates in decades last year. A key reason: Small businesses received much less credit in this recovery than in previous ones. Newly formed businesses, normally an engine of job creation for younger workers, provided less than 0.8% of all hires in 2014, the lowest share on record.
The Fed took powerful emergency action in 2008 to treat the financial crisis, cutting rates to zero and launching more than $1 trillion in mortgage bond purchases. Maybe that particular medicine was necessary for the crisis, but it didn’t work in the recovery and should have been wound down. Instead, the Fed kept controlling the price of credit, setting interest rates at zero and buying trillions of dollars more in bonds. The Fed now holds a mountain of very long-term bonds financed largely with short-term bank debt, with no increase in its equity capital. If the Fed were regulated as a bank, the gigantic mismatch in its maturities would force a shutdown.