Amid rampant discussion of further 'quantitative easing' the market's eyes will be fixed on the Federal Reserve when it meets on Tuesday this week.
In understanding why it is unlikely for 'QE2', as it is being dubbed, to be announced at this week's meeting it is helpful to briefly review the Fed's history and the political environment in which it operates.
Argument for Fed Independence
One of the key justifications for the creation of the Federal Reserve was to "keep politics out of monetary policy". In the Federal Reserve Act passed on December 23, 1913 Congress delegated its Constitutional authority over the nation's money supply ("to coin money, regulate the value thereof") to the newly created Federal Reserve System.
The Fed is free to make independent monetary policy decisions -- such as shrinking or expanding the money supply -- without the prior approval of Congress or the President. The logic behind thus empowering the Fed is that the nation is better off with its monetary policy entrusted to an institution that -- unlike Congress and the President -- is not directly accountable to the voting public. (Not exactly a strong vote of confidence in democracy!)
The theoretical problem with allowing elected politicians to directly control monetary policy can be illustrated through the following hypothetical example of a politician seeking reelection:
The above example can also be turned around to show how it can be politically advantageous to decrease the money supply. For example, in 1833 a reduction in the money supply was orchestrated in an attempt to cause President Andrew Jackson to lose reelection.
In theory, the Fed -- by virtue of its inoculation from public elections -- can base its monetary decisions (e.g., whether to shrink or increase the money supply) on the true economic conditions, and not the election calendar.
However, the Fed is not immune from politics. In fact, Fed Board members have their own mini-election gauntlet to run. To be elected to the Fed Board a person must be nominated by the President and confirmed by the Senate. And that final step, as recent events bear witness, is proving problematic.
Senate Stonewalling Fed Appointments?
In April of this year President Obama announced nominations for the three Fed Board openings and so far none have been approved by the Senate. In fact, the last time the Federal Reserve Board had all seven positions filled was back on April 28, 2006.
On Friday came news that Senator Richard Shelby (Republican, Alabama) had rejected President Obama's nomination of Peter Diamond for the Federal Reserve Board stating "it is not clear...that his background is ideally suited for monetary policy, especially given the current challenges facing the Fed".
Of note, Diamond is considered an inflation 'dove' and close Ben Bernanke monetary policy ally. Interestingly, Diamond was also one of MIT professors a then 25-year-old Bernanke thanked for supporting his doctoral dissertation. One perhaps not so outlandish interpretation of Shelby's move is that Republicans are trying to keep the Fed paralyzed.
Diamond's appointment would help Bernanke with what has proven to be a publicly divided Fed. In the face of significant Fed Board dissent, Bernanke's consensus orientation will make him reluctant to activate QE2.
Republicans Want QE2 Postponed Until After November Elections
I've written previously about Chairman Bernanke's well documented plan for dealing with the present challenge of deflation. Put simply, his plan is to print a lot of money.
The announcement of QE2 would likely trigger a rise in stock prices. An autumn stock market rally -- in addition to signaling that the 'Bernanke Put' is every bit as solid as the 'Greenspan Put' -- could be a reelection boon for a Democratic incumbent majority that is in deep trouble.
Shelby's rejection of Diamond delays his appointment at least until Congress returns from recess in mid-September (Obama's other two Fed nominees are on ice until then as well). Don't be surprised to see the Republicans stall further until after November elections. As such, investors timing an imminent announcement of QE2 are likely to be disappointed.
In understanding why it is unlikely for 'QE2', as it is being dubbed, to be announced at this week's meeting it is helpful to briefly review the Fed's history and the political environment in which it operates.
Argument for Fed Independence
One of the key justifications for the creation of the Federal Reserve was to "keep politics out of monetary policy". In the Federal Reserve Act passed on December 23, 1913 Congress delegated its Constitutional authority over the nation's money supply ("to coin money, regulate the value thereof") to the newly created Federal Reserve System.
The Fed is free to make independent monetary policy decisions -- such as shrinking or expanding the money supply -- without the prior approval of Congress or the President. The logic behind thus empowering the Fed is that the nation is better off with its monetary policy entrusted to an institution that -- unlike Congress and the President -- is not directly accountable to the voting public. (Not exactly a strong vote of confidence in democracy!)
The theoretical problem with allowing elected politicians to directly control monetary policy can be illustrated through the following hypothetical example of a politician seeking reelection:
A politician might deem it advantageous to his reelection chances if there were a well-timed increase in the money supply. The reason? An increase in the money supply can (and often does) boost asset values (i.e., stocks, housing prices). A stock market rally -- prior to an election -- can in turn boost voter confidence. And more confident voters are less inclined to throw an incumbent politician out of office. While economic conditions may in fact make an increase in the money supply imprudent due to the post-election side effects (e.g., housing price crash), a politician's motivation to get reelected may trump economic logic.
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| U.S. President Andrew Jackson vs. the Bankers |
In theory, the Fed -- by virtue of its inoculation from public elections -- can base its monetary decisions (e.g., whether to shrink or increase the money supply) on the true economic conditions, and not the election calendar.
However, the Fed is not immune from politics. In fact, Fed Board members have their own mini-election gauntlet to run. To be elected to the Fed Board a person must be nominated by the President and confirmed by the Senate. And that final step, as recent events bear witness, is proving problematic.
Senate Stonewalling Fed Appointments?
In April of this year President Obama announced nominations for the three Fed Board openings and so far none have been approved by the Senate. In fact, the last time the Federal Reserve Board had all seven positions filled was back on April 28, 2006.
On Friday came news that Senator Richard Shelby (Republican, Alabama) had rejected President Obama's nomination of Peter Diamond for the Federal Reserve Board stating "it is not clear...that his background is ideally suited for monetary policy, especially given the current challenges facing the Fed".
Of note, Diamond is considered an inflation 'dove' and close Ben Bernanke monetary policy ally. Interestingly, Diamond was also one of MIT professors a then 25-year-old Bernanke thanked for supporting his doctoral dissertation. One perhaps not so outlandish interpretation of Shelby's move is that Republicans are trying to keep the Fed paralyzed.
Diamond's appointment would help Bernanke with what has proven to be a publicly divided Fed. In the face of significant Fed Board dissent, Bernanke's consensus orientation will make him reluctant to activate QE2.
Republicans Want QE2 Postponed Until After November Elections
I've written previously about Chairman Bernanke's well documented plan for dealing with the present challenge of deflation. Put simply, his plan is to print a lot of money.
The announcement of QE2 would likely trigger a rise in stock prices. An autumn stock market rally -- in addition to signaling that the 'Bernanke Put' is every bit as solid as the 'Greenspan Put' -- could be a reelection boon for a Democratic incumbent majority that is in deep trouble.
Shelby's rejection of Diamond delays his appointment at least until Congress returns from recess in mid-September (Obama's other two Fed nominees are on ice until then as well). Don't be surprised to see the Republicans stall further until after November elections. As such, investors timing an imminent announcement of QE2 are likely to be disappointed.
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