One year ago the U.S. economy was robust with unemployment at historically low levels and real incomes rising. No one would have predicted that a year later the economy would come to a halt and more than 20 million people would be applying for unemployment benefits. This reversal was not due to monetary instability, which has been the primary cause of most recessions, but rather to a decision by government officials to mandate business closures to battle a pandemic. The initial sharp supply-side effect of COVID-19 quickly turned into a strong demand for cash and a corresponding decline in the velocity of money.

Fed's Response to the Pandemic

The Fed responded rapidly and dramatically to keep the U.S. economy from descending into depression. Monetary policymakers reduced the benchmark fed funds rate to near zero; promised to more than double the size of the Fed's balance sheet by engaging in large-scale asset purchases of Treasuries and mortgage-backed securities, with the intent of reducing longer-run interest rates; and restarted or created a number of special purpose vehicles (SPVs), which are off the Fed's balance sheet, to stabilize a broad array of financial markets.[1] The U.S. Treasury has worked closely with the Fed to backstop lending and increase leverage, providing $454 billion to cover potential losses from the Fed's lending programs to private firms under the CARES Act (an acronym for Coronavirus Aid, Relief, and Economic Security). With leverage estimated at 10 to 1, the Fed may lend as much as $4.54 trillion—none of which would show up as part of the federal deficit (see Ip and Torres).

Risks to Monetary Control and Independence

By monetizing much of the new federal debt and engaging in credit allocation, the Fed risks sacrificing monetary control and its independence. Of course, the Board of Governors could increase the rate of interest it pays on excess reserves to keep inflation at bay. However, in so doing, it would deprive the Treasury of revenue to help reduce budget deficits.

The more serious issue for the Fed's credibility and independence is the drift into fiscal space. As Charles Plosser, former CEO and president of the Federal Reserve Bank of Philadelphia has warned: "Independence is drifting away and after this [COVID-19] crisis it will be easier and easier for politicians to seek Fed participation in off-budget fiscal actions."[2]

The Fed's decision to set up SPVs to purchase corporate and municipal debt opens the door for all sorts of mischief (see Timiraos). Likewise, the Term Asset-Backed Securities Loan Facility (TALF) now accepts more risky assets, including commercial mortgage securities and collateralized loan obligations. As such, the Fed will be buying "the worst shopping malls in the country and some of the most indebted companies." Consequently, "the opportunities for losses will be that much greater," according to an editorial in the Wall Street Journal.

In 2001, J. Alfred Broaddus and Marvin Goodfriend, warned that expanding the Fed's portfolio beyond Treasuries poses risks to the Fed's credibility and independence:

The Fed's asset acquisition policies should support monetary policy by protecting the Fed's independence. . . . First, the Fed's asset acquisitions should respect the integrity of the fiscal policymaking process by minimizing the Fed's involvement in allocating credit across sectors of the economy. Second, assets should be chosen to minimize the risk that political entanglements might undermine the Fed's independence and the effectiveness of monetary policy.

The Fed's decision to pay interest on excess reserves, in October 2008, means it can separate its balance sheet size from the stance of monetary policy. As Goodfriend explains:

Central banking is understood in terms of the fiscal features of monetary, credit, and interest on reserves policies. Monetary policy—expanding reserves by buying Treasuries—transfers all revenue from money creation directly to the fiscal authorities. Credit policy—selling Treasuries to fund loans or acquire non-Treasury securities—is debt-financed fiscal policy. Interest on reserves frees monetary policy to fund credit policy independently of interest rate policy.

He argues that "An ambiguous boundary of responsibilities between the Fed and the fiscal authorities contributed to economic collapse in fall 2008."

Charles Plosser made a similar argument in his 2018 article, "The Risks of a Fed Balance Sheet Unconstrained by Monetary Policy":

A large Fed balance sheet that is untethered to the conduct of monetary policy creates the opportunity and incentive for political actors to exploit the Fed and use its balance sheet to conduct off-budget fiscal policy and credit allocation.

The Fed's response to COVID-19 has increased the chances that the Fed's balance sheet will stay immense for a long time. Returning to "normal" would require shrinking the balance sheet and returning to a corridor-type operating system that restores the link between the balance sheet and monetary policy (see Selgin).

Insulating Monetary Policy from Credit Policy

Long ago, Clark Warburton saw the inherent danger in "too close a linkage of monetary expansion and contraction with expansion and contraction of indebtedness" (p. 301).[3] From the experience of World War II, he warned: "Whenever the federal government wishes to borrow money in large amounts, the Federal Reserve Board ceases to be an independent agency" (p. 309). He attributed that to

the combination of (a) emphasis on the accommodation of borrowers rather than maintenance of a suitable quantity of money in the economy, and (b) a specific provision that, in case of any apparent conflict between the powers of the Board and those of the Secretary of the Treasury, the Board shall exercise such powers under the supervision of the Secretary of the Treasury [ibid.].

Warburton wrote that passage in December 1946, prior to the Treasury-Federal Reserve Accord in 1951, which led to the end of the Fed's obligation to support the prices of government securities, by pegging interest rates at artificially low levels, in 1953. The "specific provision" he was referring to still exists in the Federal Reserve Act and is relevant for the current war on COVID-19. Section 10 of the Act states:

Nothing in this chapter . . . shall be construed as taking away any powers heretofore vested by law in the Secretary of the Treasury which relate to the supervision, management, and control of the Treasury Department and bureaus under such department, and wherever any power vested by this chapter in the Board of Governors of the Federal Reserve System or the Federal Reserve agent appears to conflict with the powers of the Secretary of the Treasury, such powers shall be exercised subject to the supervision and control of the Secretary [italics added].[4]

Today, we are in danger of returning to a state of affairs before the famous Accord. Indeed, there has been discussion at the Fed about pegging longer-term interest rates under a program called "yield curve control" (YCC). The idea is to have the Fed commit to buy longer-term bonds to support their prices and thus peg their yields at whatever rate is decided upon, most likely under consultation with the Treasury. Although the Fed may see this as a way to "stimulate" the economy, it could also be a way to fund fiscal deficits at an artificially low rate. Sage Belz and David Wessel of the Brookings Institution have examined the YCC proposal's benefits as well as its downsides. With respect to the latter, they write:

Like other unconventional monetary policies, a major risk associated with yield-curve policies is that they put the central bank's credibility on the line. They require that the central bank commit to keep interest rates low over some future horizon; this is exactly why they can help encourage spending and investment, but it also means that the central bank runs the risk of letting inflation overheat while holding to its promise. If the Fed, for example, were to commit to a 2-year peg, they would be betting on the fact that inflation will not run well above its 2 percent target in that period. If it does, the Fed may have to choose between abandoning its promise about the peg or not holding to its stated inflation objective—both bad options in terms of its credibility with the public.

The odds are that, given large fiscal deficits and high unemployment, there would be strong pressure by the Treasury to maintain the peg and have the Fed accept a higher inflation rate—at least in the short run. Section 10 would give the Treasury the authority to do so. There is no doubt that the credibility and independence of the Fed would suffer in the process.

Under the CARES Act, Congress appropriated nearly $500 billion for the Treasury to cover potential losses from the Fed's lending programs—designed to support businesses, households, states, and municipalities. Consequently, Fed independence is already compromised.

Warburton wanted to insulate monetary policy from credit policy. He recognized that the goal of the Fed should be to provide for monetary stability and allow markets to determine the allocation of capital via freely determined interest rates, which are relative prices indicating preferences for current versus future consumption, as well as the productivity of capital. In a free enterprise system and monetary equilibrium, the natural rate of interest will coordinate the plans of millions of savers and investors, bringing about a voluntary allocation of resources between capital goods and consumer goods. Because time preferences and capital productivity are normally positive, the natural rate of interest should also be positive.

Writing in 1948, Warburton (p. 290) argued:

The rate of interest must be free to respond to real changes in the demand and supply of loan funds, in order to avoid producing monetary maladjustment, and there is no method of judging accurately the "correct" level of interest rates except when monetary maladjustment is avoided.

By not having a monetary rule aimed at a stable, noninflationary growth of nominal income and instead trying to use interest rates to guide monetary policy, the Fed has followed what Warburton called "upside-down" monetary policy. In his opinion, this practice is a "fatal error." As Warburton (p. 233) explained in his June 1947 article in the Journal of Political Economy:

Interest-rate regulation came into vogue as the chief instrument, and later as the objective, of monetary policy. The latter was a fatal error—for it turned the quantity-of-money interest-rate relationship upside down. Central banks tried to use variations in the interest rate both as a technique and as a guide for the provision of a suitable quantity of money in the economy, whereas they should have used provision of a suitable quantity of money as a technique for achieving price-level stability and freedom of the rate of interest.

He goes on to say, "This upside-down monetary policy, under the circumstances of the late 1920's and early 1930's, proved to be as disastrous as an attempt to build a sky-scraper's foundation from the architect's plans for its tower."

When the Federal Reserve was established in December 1913, it adhered to the "convertibility principle" of monetary control. That principle no longer applies, but the Fed has never adopted what Warburton calls the "responsibility principle" of monetary control, which applies to a pure fiat money regime. Under such a principle, there would be a rules-based regime aimed at safeguarding the value of money and avoiding what Warburton called "erratic money"—that is, variations in the quantity of money that are either excessive or deficient, bringing about inflation or depression. Warburton thought "the most suitable guide for the exercise of monetary power" would be to maintain "a rate of growth in the money supply equal to the combined rates of growth in population and production of final products per capita, adjusted for trend in the circuit velocity of money" (p. 396). Based on historical data, he suggested a growth rate of 5 percent per annum (pp. 358–59).

Warburton (p. 316) criticized the state of monetary law in the United States, arguing that it is "ambiguous and chaotic, does not contain a suitable principle for the exercise of the monetary power held by the Federal Reserve System, and has caused confusion in the development of Federal Reserve policy." He distinguished between "monetary control" and "loan control," with the former dealing with "the creation of money" and the latter with "the borrowing of money already in existence" (p. 298). The proper function of the Fed, according to Warburton (p. 401), is to "regulate the supply of money and leave interest rates on various types of loans, including United States government obligations, to be determined by the forces of supply and demand impinging upon the market where money is borrowed."

Warburton's historical insights are worth considering in thinking about the future path of monetary policy and Fed independence. The wide discretion and power the Fed has been given is a far cry from that envisioned at its founding. The financial crisis led to unconventional monetary policies that were to be "normalized" after the crisis. Yet the sudden onset of the COVID-19 crisis has compounded those policies and added new powers. The case for monetary control is still relevant, even though the proper monetary rule is debatable. Given the size of the Fed's balance sheet and the fiscal deficit, it will be hard for the Fed to limit its credit policies and let market forces determine interest rates. Thus, its independence is likely to remain compromised for some time, just as it was during World War II until the Accord.

Broaddus and Goodfriend would agree with Warburton. Monetary policy must be kept separate from fiscal policy. "To formulate and carry out monetary policy effectively, the Fed must maintain a high level of independence within the government, and its asset acquisition practices must support and reinforce that independence." That means "precluding the use of the Fed's off-budget status to allocate credit across various sectors of the economy" and insulating "the Fed from political entanglements that could undermine its independence." Those objectives would be realized if the Fed restricted "its asset portfolio to Treasury securities." The authors warn that straying from a Treasuries only policy "would present significant risks to the integrity of fiscal policy and to the Fed's independence, and hence to the quality of U.S. monetary policy."

The Fed, of course, has moved in the opposite direction. Turning back may be very difficult and politically untenable, so long as there is little fiscal rectitude and interest rates must be kept near zero to fund massive government debt. Knowing that the Fed will "do whatever it takes" to prop up asset prices and keep rates low, there will be a continued reach for yield, an increase in risk taking, and a fleecing of risk-adverse savers. Capital formation will suffer and prospects for economic growth will diminish. The desired wealth effects from "easy money" will end up being a mirage. Taxpayers will ultimately bear the burden of the debt—either through higher future taxes or inflation. There is no free lunch.

Conclusion

The COVID-19 pandemic has led to an unprecedented expansion of Fed power and discretion. It has led to the transfer of fiscal responsibility to the Fed and weakened the Fed's independence. The drift into fiscal policy and credit allocation—as opposed to pure monetary policy (i.e., allowing the size of the balance sheet to influence money, prices, and nominal GDP)—places the Fed in a precarious position. The lack of a rules-based monetary regime increases uncertainty and opens the Fed to further politicization. Too much is asked of monetary policy and too little responsibility is placed on Congress for difficult fiscal decisions.

After the 2007–09 financial crisis, the Fed failed to fully normalize its balance sheet and, in setting its policy rate, it stuck with the "floor system" that was first instituted in October 2008. That system has allowed the Fed to respond to COVID-19 by massively expanding its balance sheet without fueling inflation. Meanwhile, the Fed's off-balance sheet lending programs, created under the authority of Section 13 (3) of the Federal Reserve Act, have been dramatically expanded in response to the pandemic.

The challenge, in the wake of COVID-19, will be to limit the Fed to its proper role of providing monetary stability, while allowing competitive capital markets to freely set interest rates and allocate funds. To meet that challenge, according to Plosser, means:

The Fed should not be allowed to engage in fiscal policy actions that rightly belong to the fiscal authorities. Without carefully established constraints on the size and composition of the Fed's balance sheet, credit allocation and off-budget fiscal policy represent discretionary opportunities ripe for abuses that would undermine the case for political independence. Such authorities are likely to prove detrimental to our institutions and the economy.

In a world of scarcity and uncertainty, tradeoffs are inevitable. The pandemic was not the Fed's fault, nor was the political decision to lockdown the economy and put millions of people out of work. In such a situation, the Fed had to act quickly and decisively to provide liquidity to prevent financial instability from leading to further deterioration of the real economy. But the Fed's actions are meant to be temporary, not permanent. Ensuring long-run economic growth necessary to restore economic well-being will require adapting to new realities via markets, not manipulating interest rates to finance government deficits and providing cheap credit to favored groups.

Several fundamental issues will need to be addressed when the pandemic ends: Will the Fed be able to downsize along with the government? Will fiscal policy continue to dominate monetary policy? Will interest rates continue to be pegged at low levels to finance ever growing fiscal deficits? The answers to those and related questions will determine both the path of economic life and the scope of personal freedom. They are too important to be left solely to policymakers.

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[1] For a detailed discussion of the Fed's SPVs, see Cheung.

[2] Correspondence with author, April 18, 2020.

[3] All text references are to Warburton's 1966 book: Depression, Inflation, and Monetary Policy: Selected Papers, 1945–1953 (Baltimore: The Johns Hopkins Press). Page numbers are indicated.

[4] See 12 USC 246.