The Federal Reserve is in danger of losing control of how it sets interest rates, according to the former chairman of the Senate Banking Committee.
Texas Republican Phil Gramm argues in a Wall Street Journal op-ed that the central bank's attempt to normalize interest rate policy while it also reduces the size of the securities it holds on its balance sheet could go terribly wrong.
In a piece co-authored with Thomas S. Saving, a former director of the Private Enterprise Research Center at Texas A&M University, Gramm notes the intensifying debate over whether the Fed should be raising interest rates. The central bank hiked its benchmark rate four times in 2018 and reduced the amount of Treasurys and mortgage-backed securities it holds by $136 billion, or 3.4 percent, to $3.88 trillion.
President Donald Trump has repeatedly criticized Fed Chairman Jerome Powell and his colleagues for policy tightening. Markets have been in turmoil as well, with stocks threatening to fall into bear market territory.
"Extraordinarily, this debate is occurring at the very moment the Fed — shackled by its bloated asset holdings and the resulting excess reserves of the banking system — has less ability to control interest rates than it has had in its entire 105-year history," Gramm wrote.
The issue is the balancing act the Fed must perform as it seeks to normalize policy from the extreme accommodation of the financial crisis and the years after.
The Fed is both raising rates and reducing bonds it holds on its balance sheet, and in 2018 ran into an issue in which the benchmark funds rate veered close to and eventually matched the same level as the interest the Fed pays on excess bank reserves. Gramm pointed out that should the market rate banks can make on loans exceeds the level the Fed pays on reserves, it could result in an explosion in the money supply that would drive inflation.
"[T]he danger posed by the Fed's bloated asset holdings and the resulting massive level of excess bank reserves is that with a full blown recovery now under way, the demand for credit will accelerate and force the Fed to move quickly to raise interest rates on reserves or sell securities to sop up excess reserves," Gramm and Savings wrote. "A small error by the Fed in following market interest rates could cause a large change in the money supply."
The op-ed places much of the blame for the current situation on "monetary excesses" during the administration of former President Barack Obama.
Gramm himself, though, has often been cited by critics for contributing to the financial crisis. He advocated the repeal of the Glass-Steagall Act that had mandated the separation of retail and investment banking, and pushed for deregulation of the credit default swaps that played a key role in Wall Street's crisis-era troubles.
He expressed some optimism that the Fed will be able to navigate its way through the current situation but said it will take time.
"While the Fed is not forever shackled by the monetary excesses of the Obama era, the sheer size of its asset holdings virtually guarantees that the Fed will feel the yoke of the massive excess reserves in the banking system for the remainder of this recovery," he wrote.
Read the full op-ed here.