Inside the Debate Over the Fed’s Extralegal Mandate Expansion

Earlier this month, Fed head Jerome Powell did what central bank chiefs usually do in a crisis: He went on 60 Minutes. His comments on the recovery’s potential length took most headlines, but economic policy wonks zeroed in on something different: a de facto admission that the Fed’s extraordinary actions in March and April exceeded the central bank’s mandate and expanded its original function well beyond anything in legislation. That has spurred a wave of think pieces on the wisdom and potential long-term consequences of these decisions, and in our view, they raise some valid points. These issues are worth weighing, and they could indeed have long-term ramifications. Yet we also think it is important for investors to distinguish long-term academic debates from issues that can affect markets in the here and now, and we think the case of the Fed’s mandate breach falls squarely in the former category. Projecting how this all ends amounts to sheer speculation and isn’t productive for investors to get hung up on today, in our view.

Since the 1970s, the Fed has had two main roles: adjusting monetary conditions to foster maximum employment with stable inflation (the famous dual mandate) and, the one it was created for in 1913, serving as lender of last resort during a crisis. That second part is traditionally limited to banks. In normal times, banks meet short-term obligations by borrowing from each other—a way for banks to keep the financial system liquid and stable while earning a very small return on spare cash. But when the system gets stressed, those short-term funds can dry up. When this happens, the Fed steps in, providing short-term loans to carry solvent-but-illiquid banks through a rough patch. It is a bridge to better times, not a bailout—a move designed to mitigate the broad economic impact of vast bank runs and panics that characterized 19^th century America.

This time around, banks were in overall fine shape. The COVID crisis didn’t destroy their balance sheets or cause funding markets to freeze. Instead, as Powell pointed out, it was the “real economy” that saw funding disappear. That is pundit-speak for normal households and businesses small and large. Furloughed workers weren’t receiving paychecks. Businesses forced to close weren’t bringing in revenues. Larger companies that would ordinarily tap bond markets saw demand for new issuances dry up as investors fretted credit rating cuts and the potential for longer-than-expected closures to raise bankruptcy and default risk. Small businesses without significant collateral faced high hurdles to obtaining bank loans. State and local governments faced tax revenue shortfalls, raising fears of big deficits and troubles in muni bond markets. So, identifying those myriad trouble spots, the Fed chose to intervene as lender of last resort—not to banks, but to businesses, households and municipal governments. Or, if you prefer, to Main Street.

Without passing any judgment, we think it is important to realize this move goes pretty far beyond anything the law actually authorizes the Fed to do. It requires a fairly creative and expansive interpretation of its powers. In our view, there is definitely an argument to be had about whether it was appropriate for the Fed to ask for forgiveness rather than permission in taking these actions. Several weeks on, we think there is evidence that, while not all of the Fed’s new tools were necessary, some will probably turn out to be a net benefit, and it was a time of severe economic stress under unprecedented circumstances. For instance, we don’t think it is necessary for the Fed to purchase corporate bonds, as even the so-called fallen angels who lost their investment-grade credit ratings were, in many cases, overall sound. In our view, the market is generally quite good at seeing through the veneer of credit ratings and awarding funds where they will be best used with the highest likelihood of repayment. But in a time when investors were hoarding cash, if the Fed’s backstopping corporate debt was what it took to get the bond market moving again, perhaps it was a worthwhile endeavor. Without a counterfactual, we will never know for sure what would have happened if the Fed hadn’t stepped in, so it is impossible for anyone to argue definitively whether the ends justified the means. All we can do is acknowledge the primary impact.

At the same time, the Fed isn’t an independent institution in the strictest of senses. It is accountable to Congress, and its remit is written in law. Its decision to launch all these Main Street lending facilities transferred what arguably should have been a major political decision from Congress to a cabal of unelected monetary policymakers. At its core, it is a rather gobsmacking instance of administrative creep. In some cases, particularly the small business assistance program, Congress seems to have blessed the Fed’s actions after the fact. But they haven’t rubber stamped everything, and the saga still raises questions about which body is leading the expansion of the Fed’s powers.

As a result, we think the post-hoc scrutiny that will no doubt occur at Powell’s next few appearances before Congress will be well-deserved, and it won’t surprise us at all if there are eventually legislative changes. But it isn’t clear whether those changes would remove any and all Fed latitude to go outside its pre-existing mandate—or broaden that mandate and give the Fed a host of new powers. Maybe this will politicize monetary policy in ways many economists fear. Maybe we will all collectively look back on it as a one-off never to be repeated. Maybe that collective view will prove wrong. It is impossible to know today. Heck, we don’t even know what Congress will look like after November’s election.

Markets move most on probabilities, not possibilities. Most likely, this is an issue that will play out over a very long time in Congress, with lawmakers publicly debating and watering down various proposals. That long debate will give markets time to gradually digest their plans and potential unintended consequences, giving investors plenty of time to make any adjustments necessary. Getting too hung up on the issue now, with so much unknown, is fruitless. You can’t handicap winners and losers from regulatory changes until you know what those changes will be. Besides, much of this smacks of hunting for the proverbial “second shoe to drop”—a common sentiment feature in bear markets.

With that all said, if monetary and regulatory policy is your cup of tea, this academic debate will probably be manifestly interesting. So by all means, keep an eye on the discussion if you like, and enjoy discussing all of these opinion pieces over your quarantine cocktails. But we suggest not letting it influence investment decisions in the here and now.