Alaric Securities celebrates at Nasdaq MarketSite
September 13, 2023 | Issue 38

Opinion: The Federal Reserve Needs to Be Regulated

Alaric Securities
Managing Partner at Alaric Securities
Federal Reserve Seal: symbol of financial stewardship in a changing landscape - examining fed policy and the call for regulatory oversight

A Call for Accountability, Transparency, and Global Foresight

First, let’s start with some history – The Federal Reserve (the Fed) was established in 1913 with the Federal Reserve Act after a series of market crashes, the most notable of which was the panic of 1907. In the beginning, the role of the Fed was only to mitigate the effects of panics in the financial markets.

Later, Congress expanded the mandate of the Fed to include three objectives – price stability, maximum employment, and moderation of long-term rates. In our opinion, this is not enough.

From our point of view, we should expand the Fed’s mandate to encompass the stability and integrity of the global financial system. The actions of the Fed during the 2008 Global Financial Crisis proved that the Fed could and should consider the impact of its decisions domestically and globally. That is why we need to expand the Fed’s mandate to reflect the globalized world we inhabit.

While one could argue that the Fed implicitly follows that mandate already, we believe this falls short, and formally adopting such an expanded mandate is necessary.

The Federal Reserve’s Balance Sheet: Too Big to Fail?

Second, the Fed is currently the largest hedge fund the world has ever seen. It has a balance sheet of 8.2 trillion USD, or about 30% of the US GDP. 2008, the size was under one trillion USD, representing about 7% of GDP.

Furthermore, while debt instruments primarily fueled the initial growth of that balance sheet, they expanded the mandate to include ETFs and other non-plain vanilla instruments in 2020.

It’s important to note that although an external auditor and the Government Accountability Office (GAO) regularly audit the Fed, simple audits fall short of sufficiency.

We believe Congress should address the size and complexity linked to such an immense balance sheet. At the very least, to avoid conflict of interest or appearance of impropriety.

The Federal Reserve’s Decision-Making Process: A Black Box?

Third, the Federal Reserve is practically the only financial institution in the US that operates by “the seats of their pants.” Pardon our French here. Any economic entity must prepare a business plan to get any financial license. We don’t need to write this business plan in stone. Companies continuously adapt their business plans, but some planning, especially long-term planning, seems necessary.

The Federal Reserve does not reveal how it makes decisions – even guiding principles. FOMC is usually very secretive about how they interpret data. History tells us that biases of guiding principles, whether conscious or subconscious, vary with different chairmen (or chairwomen). So, under Chairmen Bernanke, FOMC would have made one decision, under Chairman Powell – another, using the same data.

The Federal Reserve’s View of the World: Too Naïve?

Finally, the Fed operates from a “naïve view of the world.” The naïve view of the world holds that one expert or small group can correctly predict the future if they can access enough data.

We do not mean to say that it is impossible. It is just that a large and diverse group of experts, even if not privy to all data, is better than a small group of experts on future predictions. We call this large and diverse group of experts “the wisdom of the crowd.”

The example here is the 5-year breakeven rate:

5-year breakeven rate in connection with Federal Reserve policy

In May 2021, Mr. Powell used the word transitory to describe the inflation of 2021. At the same time, the 5-year breakeven inflation rate (expected 5-year inflation) was at 2.7%. A level much higher than at any time in recent history.

Recently, Mr. Powell described the present level of inflation as uncomfortably elevated. Well, the wisdom of the crowd is expecting inflation in the next five years to average 2,16%. While the future is uncertain, the crowd’s wisdom is brighter in the long run than any individual or group.

Conclusion: The Fed Needs to Be Held Accountable

In conclusion, we want to say that Congress needs to revisit the Federal Reserve Act. The world has changed dramatically over the last several decades, and the Fed’s roles have grown significantly.

Currently, there is little accountability for the decisions made by FOMC. We believe that it is essential to focus on how FOMC operates.

Just as airplane pilots file flight plans, the Federal Reserve should adhere to a more structured approach, fostering transparency, responsibility, and global foresight.

Disclaimer

The articles, podcasts, and newsletters from Alaric Securities LLC solely represent the authors’ views affiliated with the company; they do not represent the perspectives of Alaric Securities OOD or any of its subsidiaries or affiliates. They are provided solely for informative purposes and do not constitute recommendations for or against purchasing or selling security. Digital assets (such as cryptocurrency) or other assets in any account. They are neither research reports nor meant to be the foundation for any investing decisions. Any third-party information given does not represent the views of Alaric Securities OOD or any of its subsidiaries or affiliates. All investments carry risk, including the potential loss of principal, and past success does not assure future success.