By Matthew C. Klein
Illustration by Joel Arbaje
Investors spent the past week obsessed with Federal Reserve Chairman Jerome Powell’s testimony to Congress. But they may have been focused on the wrong thing.
The markets were looking for a sign that the Fed would keep the rally going. But that shortsightedness overlooks the central bank’s most important task: monetary stability. When money holds its value, consumers want to spend, and companies want to invest. Monetary instability can damage the economy, and in extreme circumstances, even lead to depressions.
The U.S. Constitution gives Congress the power to “regulate the value” of money to prevent these problems. Most money, however, is produced by the private sector: More than 90% of America’s money supply takes the form of short-term debt issued by banks and other financial firms, rather than physical currency printed by the Treasury. That private debt is largely backed by risky assets, such as long-term loans to businesses and consumers.
The result is “a monetary system in which the private part is vital, but inherently unstable,” as Paul Tucker, the former deputy governor of the Bank of England and the current chairman of the Systemic Risk Council—a nonpartisan body formed by the CFA Institute and the Pew Charitable Trusts—wrote in a recent essay.
Governments are tasked with stabilizing this inherently unstable system. Unfortunately, Tucker argues, officials are hampered in their efforts by their incompatible assumptions about how the economy works. The danger is that they will “adopt policies that err on the side of softness” at the expense of “resilience”—meaning that devastating crises would become more likely, thanks to looser regulations.
Inflation and bank failures are the two traditional threats to the integrity of the monetary system. Because they seem distinct, central banks generally handle them separately: Sound monetary policy is supposed to prevent inflation, while prudent financial regulation is supposed to keep banks safe. The tasks are often handled by different people in different departments with different ways of thinking about the world. In Tucker’s view, this compartmentalized approach undermines both price stability and financial stability.
For example, monetary policy makers now believe that the economy’s underlying growth rate is much slower than it used to be and that interest rates have to be much lower than in the past to generate enough spending to keep the economy running at full capacity. Since the Fed began publishing long-term forecasts at the beginning of 2012, officials’ estimates of the “normal” level of short-term interest rates have dropped by roughly two percentage points. Central banks, therefore, have less room to fight recessions by lowering borrowing costs.
Combined, these developments have significant implications for the valuation and riskiness of banks’ assets.
First, as Tucker puts it, “loans originated prior to the realization that growth is low will be riskier than originally believed, [and] expected losses will be higher.” Businesses borrowing in anticipation of rapid sales growth will be disappointed, while consumers hoping to repay their debts out of higher incomes may be forced to default.
Worse, the slower pace of trend growth and the limited scope for monetary stimulus caused by lower rates means “there would be little or no scope for borrowers in general to grow out of debt overhang problems.” Banks cannot wait for bad loans to fix themselves if downturns are deeper and recoveries are weaker.
Banks, therefore, have less scope to absorb losses than they think, which means they are borrowing too much. There is not enough equity to protect depositors and other short-term creditors. Unfortunately, the banking regulations written in 2010-11 were calibrated using old data and have not been updated to reflect the new economic outlook. Whatever levels of bank equity people thought were appropriate for a world of structurally faster growth and higher interest rates are therefore too low for today’s environment.
In theory, regular stress tests could help remedy these deficiencies. That is not what is happening. A recent Fed study found that the tests are becoming decreasingly challenging, despite increasingly dire macro scenarios. The “severely adverse” macro scenario in the 2019 test, for example, assumed U.S. gross domestic product would drop twice as much as in the Great Recession, but that pretax net income would fall less than 1%, relative to total assets.
Over the three years of the forecast period, the 18 major banks tested would supposedly experience about $296 billion in total loan losses—far less than the $430 billion written off by the biggest banks during the financial crisis’s three worst years.
Monetary policy makers would also benefit from learning more about the financial system when setting interest rates. The old assumption was that rate cuts reliably boosted the economy by encouraging households to borrow and spend. This damps short-term swings in the business cycle. But, over longer periods, it increases debt and makes crises more likely. Eventually, the process becomes self-defeating: Rate cuts lose much of their potency once consumers are over-indebted and credit-constrained.
Despite enjoying dramatically higher home values, Americans scarred by the crisis are still cashing out less home equity than they were in the 1990s. That has suppressed consumption and made it harder for the Fed to hit its inflation target.
Stabilizing the monetary system is a challenging job. It is even harder when the people doing it are working at cross-purposes, with contradictory models of the economy and financial sector.
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