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Instead of audit, maybe the Fed needs stress test

The Federal Reserve
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The Federal Reserve

Every year, the Federal Reserve takes it upon itself to conduct stress tests of the nation's biggest banks, measuring them for how well they would hold up under the weight of another crisis the likes of which engulfed the financial system in 2008 and 2009.

The results purport to give a clear picture of the financial system's health.

What's less clear, though, is how the Fed itself would hold up under similar circumstances. Rather than subject the Fed to a closet-cleaning audit, as is the desire of Rand Paul, the Republican senator and presidential candidate, a more instructive move could be a stress test of whether the central bank could meet its responsibilities in the event of another crisis. (Tweet this)

The Fed, of course, would be highly unlikely to fail a bank-type stress test per se. However, it could come up considerably short in terms of the ammunition it would need to help the financial system deal with another major crisis caused by an unforeseen event. With interest rates already at zero and the central bank's balance sheet bloated, through quantitative easing, to $4.5 trillion, the Fed's cupboard is currently pretty bare as far as easing ingredients go.

The stress test parameters, of course, would be different for a Fed stress test: The central bank doesn't take customer deposits or make loans to anyone other than its member institutions. And there is one other major difference between it and a commercial bank: The Fed can simply print money whenever it wants, so it doesn't ever have to worry about being illiquid.

This institution does, though, serve a vital role both for the banking industry and the economy as a whole. It uses the policies within its purview to help steady financial conditions in times of crisis, in addition to meeting its dual mandate of price stability and full employment.

Over the past 6 ½ years, the Fed's two weapons of choice have been printing money, or more precisely, creating it digitally, to buy up various securities including U.S. Treasurys and mortgage-backed securities; and keeping its short-term target funds rate near zero.

The conjoined acts have resulted in the largest Fed balance sheet ever and never-before-seen zero interest rates amid an easing cycle that has lasted well beyond the mid-2009 endpoint of the recession the financial crisis helped create.

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Those historically aggressive actions also have left the Fed with few tools left to affect conditions should a crisis arise. After all, it can't—or at least is extremely unlikely to—drop nominal rates below zero, and balance sheet expansion both would be likely to invite a storm of criticism and unlikely to have a huge effect.

At least by these nonstandard measures, then, the Fed could flunk this type of stress test.

"The Fed's really out of a lot of bullets here," said Ted Peters, a former member of the Philadelphia Fed board. Whether the Fed would be able to navigate the economy out of another crisis, he said, "really depends on what type of crisis occurs."

Indeed, the Fed itself is banking against a banking crisis, or least a situation where liquidity would be an issue.

The stress tests' very existence is to make sure banks have plenty of cash on hand should a sharp recession hit. By that measure, the Fed's actions have been a success, with balance sheets in aggregate well above the Fed's targeted level.

Speaking at a question-and-answer event Thomson Reuters held last week, New York Fed President Bill Dudley pointed to liquidity conditions as an important brace that would alleviate the need for aggressive Fed action should a sudden crisis or broader recession hit.

"In some ways we're in much better shape today than we were in 2007," Dudley said in a response to a CNBC.com question about a Fed stress test. "The toolkit is a lot fuller today than it was back then."

Like a good doctor, the Fed's strategy is to "keep your patients healthy," but "when they get sick you treat them well," he said. Dudley did acknowledge that "the next crisis could be a lot different than this one," but he didn't list any examples of how the Fed might react.

The most obvious move would be balance sheet expansion through more QE.

However, that would open the Fed up to criticism, particularly in Washington where foes of the central bank believe the easing has led to distortions in capital allocation. While the stock market has zoomed over the past six years, economic growth has remained tepid—below or barely at historical averages amid the slowest post-recession recovery since the Great Depression—and wealth disparity metrics have expanded.

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Some believe another round of QE might not even help the stock market.

"They can't lower interest rates, so ... they would be left with another round of QE," said economist and frequent Fed critic Michael Pento, founder of Pento Portfolio Strategies and author of "The Coming Bond Market Collapse," a book positing that Fed policies ultimately will cause the fixed income market to crash. "How would the stock market react? Maybe it would go up, maybe it wouldn't. My theory is it would not. I feel that investors understand that equity prices are a function of earnings growth and economic growth."

The question of what artillery does the Fed have left becomes more relevant when considering current conditions; The next two quarters of corporate earnings are expected to show negative growth when compared to the prior-year periods, and the economy, according to the latest projections from the Atlanta Fed, may have grown just 0.1 percent in the first quarter.

"If you look at the broad set of data that we've gotten in recent weeks and months, the data has very much surprised to the downside," said Dudley, who added that it's within reason to expect the Fed to stay lower for longer

Ultimately, that's probably how the Fed will try to compensate for not having the tools to deal with the next crisis—by not relinquishing the ones it feels were instrumental in resolving the last one.