The Fed is breaking US federal law in two direct ways, skirting federal law in one important way, and disregarding the intent of Congress in a third crucial way. All of this shapes post-2008 monetary policy and distorts capital markets.
First, the Balanced Growth and Full Employment Act of 1978 fully amends the Employment Act of 1946 that regulates in law Federal Reserve action. This 1978 act stipulates an inflation rate target of 3% by 1983 and 0% thereafter. It allows leeway in not meeting this target if the unemployment rate is above 4% for aged 16 and over. This rate has been less that 4% since February 2022, and was less than 4% from May 2018 through February 2020.
In 2012 and still following this today, the Fed declared it would establish a 2% inflation rate target. This was done despite the 1978 Act’s stated provisions (Section 4.d) that only the President or Congress can modify the inflation rate or unemployment rate target. Further, the Fed in its 2012 statement disregarded the unemployment part of the 1978 Act by stating that “it would not be appropriate to specify a fixed goal for employment” even though this was already a part of the 1978 Act at a 4% unemployment rate. Declaring a 2% inflation rate target violates federal law guiding the Fed in the 1978 Act. Disregarding the 4% unemployment rate target in the 1978 Act is the second explicit violation of US statutory law.
Second the Fed is skirting federal law. Sponsored by now-retired Bill Gradison (R-Oh), the Federal Credit Reform Act of 1990 stipulates that all direct loan purchases by the US government need to be approved within Congress’s official budget by the Congressional Budget Reconciliation Act of 1974. Under President Bush, in 2008 the US Treasury bought mortgage-backed securities during the bank crisis. The expected loss on these at the time of purchase had to be included in the Congressional budget process. This is true even if the US eventually made a profit on such purchases, which is irrelevant to the Federal Credit Reform Act.
Under President Obama, instead of Treasury the Fed bought the MBS directly and continue to do this today. This skirted the Federal Credit Reform Act as the Fed purchases replaced the US Treasury purchases of MBS. In doing this, the Fed violated their own internal guidelines that prohibited action that benefited any one industry, which was the financial industry holding and issuing new mortgage loans. To address this violation, the Fed changed their guidelines to allow favoring any industry that the Fed chose. This displays the lengths by which the Fed went to skirt federal law as well as violated US law targets on inflation and unemployment.
A third action has blatantly disregarded the intent of Congressional law ever since 2008. The Fed began paying interest on all reserves held at the Fed. This was enabled through the Financial Services Deregulatory Relief Act of 2006. That act was meant to relieve small banks of the burden of holding more required reserves relative to assets than the large banks had to hold, the latter being close to negligible. Required reserves were limited up to a certain dollar amount and were set to zero on “non-depository” accounts such as money market funds. In the 2006 Act, its wording allows the Fed to pay “interest on reserves”, which was meant for the only reserves ever held previously at the Fed: required reserves. Excess reserves historically were as close to zero as banks could possibly make them. By emergency legislation in 2008, the Fed was allowed to move up the 2006 Act’s effective date of 2011 right to 2008, so that the Fed could immediately begin paying interest. But contrary to the clear Congressional intent of Senator Crapo who sponsored the legislation, the Fed paid interest on both required and all other reserves. This seemingly tiny change in the intent of federal law led to the build-up of trillions of dollars of reserves by private banks that were held at the Fed after 2008 instead of being lent out and invested in consumer and firm projects. As a result of the fungibility of money, the Fed interest rate paid on reserves then set the interest rates in all short term markets. This means that since 2008, the Fed has been setting short-term US Treasury debt rates by diktat rather than through natural equilibrium of supply and demand in capital markets.
Then the Fed totally eliminated reserve requirements on March 26, 2020 since they were no longer relevant given the “oceans of reserves” as one Fed white paper put it that were now held at the Fed instead of being invested in the US economy.
What did the Fed gain by all of these post-2008 policy changes that violated, skirted and undermined the intent of US statutory law? By financing the growing US Treasury debt after 2008, and again after 2020, the Fed could print money at an accelerated rate but it did not enter circulation as long as a large part of this was held as excess reserves at the Fed. This kept inflation down, or “suppressed.” Finally, the dam broke after 2021 when there were so much reserves created as the Fed bought US Treasury debt from banks that the reserves entered circulation at a fast rate and we found the US economy in a new prolonged episode of inflation. The Fed in the end gained little by circumventing federal law in myriad ways. But capital markets have remain distorted by interest rates lower than the inflation rate for some twenty years as a result of the Fed-set interest rate on reserves. The real return to short-term Treasury debt after inflation has remained negative and induced greater riskiness in bank equity portfolios worldwide to balance out the negative real return on Treasury debt.
The higher is the inflation rate, even above 0%, the more variable are both the inflation rate expectations and the effective inflation tax that is imposed on capital markets. This causes greater risk-premiums to be built into government debt returns. Greater risk is faced when holding “risk-free” US Treasuries, the most fundamental liquid asset used globally to create immediate reserves when needed. The increase in risk from the Fed targeting higher inflation rates than stipulated under US statutory law increases the risk of the aggregate market portfolio that is divided between “risk-free” Treasury government debt and a more risky equity portfolio. The increased risk of the aggregate market portfolio increases the riskiness of the global financial system.
Max Gillman is Hayek Professor of Economic History at the U. of Missouri – St. Louis and author of The Spectre of Price Inflation (2023).