July 8, 2013 6:35 pm

The Fed must change itself as well as its policies

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The US central bank must retreat from QE and reform its structure, says Henry Kaufman
The Federal Reserve building, Washington DC©Bloomberg

The Federal Reserve building, Washington DC

The US Federal Reserve may soon have a new chairman – and what a time to take over. Assuming Ben Bernanke leaves his post this year, his successor will inherit a serious policy challenge: disengaging from quantitative easing.

Returning to more traditional monetary policy will be tricky. First, there is no precedent in the Fed’s 100-year history. Has there ever been a period in which the US central bank and its leading counterparts worldwide have simultaneously pursued QE against a backdrop of economic faltering and uncoordinated fiscal policies?

Second, a prerequisite for ending QE is considerable evidence of a return to normalcy in economic and financial growth. Despite the good news suggested by last week’s jobs data, right now that is not yet fully visible, either in the US or abroad.

Moreover, were QE to be halted now, it would be against uncertainties about the effective functioning of larger financial conglomerates. The Dodd-Frank legislation did not resolve the too-big-to-fail problem. The Fed failed to recognise that abandoning the Glass-Steagall Act in the 1990s would accelerate industry consolidation and create more too-big-to-fail institutions.

The resulting behemoths stand in the way of returning mortgage funding to the private sector. Imagine for a moment that federal financing institutions such as Fannie Mae and Freddie Mac were somehow dissolved. As the US financial system is now structured, most new mortgage securities would be held at a handful of conglomerates deemed too big to fail.

All in all, the Fed faces a serious policy conundrum. Mr Bernanke put the recovery in jeopardy late last month with his pronouncements about withdrawing from QE. His timeline is based entirely on the Fed’s economic projections, which in recent years have proved wide of the mark.

But continuing QE may encourage unsustainable financial practices. Monetary officials have issued warnings about the emergence of speculative activities that rely on the Fed’s asset buying. Whether the Fed can deal with them selectively is uncertain. If it does, it will be a big departure from policy approaches of recent decades. A new chairman, however, should take on another big task; the Fed’s structure, as it has evolved in the past century, does not help it meet its challenges head-on.

The location of its 12 district banks, for example, is outmoded. A heavy presence in the Midwest and northeast made sense in the early 20th century as the US was still industrialising. It grew anachronistic as population and economic activity burgeoned in the west and south. California – itself the world’s seventh-largest economy – and six other western states are served by a single district (or Fed) bank, while the entire south is covered by just two district banks. Meanwhile, as in 1913, Missouri still boasts two district banks. The Fed’s governance is distorted, too, by musty rules about Federal Open Market Committee membership and voting authority. The voting members of the FOMC are the seven board governors – along with only five of the 12 district presidents. The president of the New York Fed is a permanent member – which makes sense, given the city’s continued status as a leading global financial centre. But at any given time, seven of the other district bank presidents cannot vote.

Voting rotation, likewise, is rooted in historical decisions with no relevance today. Why should the presidents of the Chicago and Cleveland Fed districts act as voting members every other year, and the presidents of the other nine distinct banks only every third year? Are the former as relevant economically and financially as decades ago?

Another area ripe for reform is the board of governors’ pay. The six governors are each paid $179,700 a year, while the chairman receives $199,700 – relatively modest sums compared with the private sector. Unfortunately, Fed officials, like many other essential government officers, often move in and out of the private sector. But Fed employees and others in key financial positions in the US government should be banned from going into financial institutions for several years after leaving government service.

Perhaps salary competition among central banks will improve the situation. It has been reported that Mark Carney, the new governor of the Bank of England – and a Canadian – will receive more than $1m annually.

We still do not know if President Barack Obama will reappoint Mr Bernanke as Fed chairman for a third term – nor if he would accept it. Mr Bernanke failed to perceive quickly the oncoming financial crisis; but, when he did, he acted with vigour and ingenuity. He has held QE in place despite apparent differences within the FOMC.

To deal with the continued economic and financial circumstances, and the Fed’s outmoded structure, a new chairman would need to show similarly bold leadership quickly.

The writer is president of Henry Kaufman & Company and author of ‘The Road to Financial Reformation’

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