Instead of audit, maybe the Fed needs stress test

The Federal Reserve
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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.