House Financial Services Subcommittee Hearing on Federal Reserve ‘s Credit Allocation
At the March 12th House Financial Services Subcommittee on Monetary Policy and Trade hearing, lawmakers examined the central bank’s role in credit allocation.
Witnesses at the hearing included: Dr. Marvin Goodfriend, Professor of Economics at Carnegie-Mellon University’s Tepper School of Business; Dr. Paul Kupiec, Resident Scholar at American Enterprise Institute; Dr. Lawrence White, Professor of Economics at George Mason University; and Dr. Josh Bivens, Research and Policy Director at the Economic Policy Institute.
Opening remarks
In his opening remarks, Chairman John Campbell (R-Calif.) expressed that he wanted to examine the idea of quantitative easing (“QE”) and interest rates through the scope of both the Federal Reserve’s (Fed) current and past actions.
Ranking Member William Clay (D-Mo.) stated that the Fed’s balance sheet has expanded from $75 billion to $85 billion due to evidence that the economy is improving and improvement in the labor market. He further stated that one of the most affected markets in the 2009 financial crisis was the housing market due to employment and wage levels.
Vice Chairman Bill Huizenga (R-Mich.) expressed that he wanted to see what the spending in QE 2, QE 3 and twist accomplished, and the effectiveness of the Fed’s efforts to stimulate the economy. He expressed a concern with the Fed’s encroachment into fiscal policy through credit allocation, which breaks down historical safeguards in its independence from the federal government.
Witnesses Testimony
In his testimony, Goodfriend stated that “credit policy has no effect on the general level of interest rates because it doesn’t change aggregate bank reserves or interest paid on reserves. Credit policy is debt-financed fiscal policy.”
In the long-term, Goodfriend continued, a departure from a “treasuries only” asset acquisition policy does not comply with Fed independence. Additionally, he said, the Fed should utilize “treasuries only” aside from occasional, temporary, and well-collateralized last resort lending to solvent, supervised depository institutions.
Lastly, Goodfriend said Fed credit initiatives beyond a last resort lending should occur only with prior agreement of fiscal authorities and only as bridge loans accompanied by take-outs arranged and guaranteed in advance by the fiscal authorities.
In his testimony, Kupiec argued that it was government policies that supported the housing bubble, leading to the financial crisis. The same policies, he said, are in place today along with new programs to stimulate mortgage borrowing.
Further, Kupiec said, “Volcker Rule restrictions on collateralized loan obligations will impose significant costs on banks with no measurable gain in bank safety or soundness. The Rule should be amended without delay to allow banks to retain their legacy CLOs.”
Another issue, Kupiec stated, is that the Fed can fail a bank in the Dodd-Frank mandatory stress test without providing any evidence that the bank is at risk. He also raised the issue of community banks, which he says have stopped offering customer mortgages due to the new mortgage orientation rules.
Kupiec said that another concern is that the Dodd-Frank Act granted financial regulators the ability to prevent “systemic risk” without a definition what entails systemic risk, which in turn expands the power of the regulating bodies.
In his testimony, White described the Fed’s attempts to direct the allocation of credit as “overreaching, wasteful, and fraught with serious governance problems.”
White said that the central bank has been charged with five tasks: the clearing and settlement of checks, issue of paper currency, supervision and regulation of commercial banks, “lender of last resort,” and monetary policy. The Fed’s implementation of credit allocation policies does not fit into any of its five tasks, White said.
The programs the Fed implemented under its credit policies, White said, “are more likely than not to have been wasteful” and to negatively impact potential users of funds who have credit diverted away from them.
White stressed that a committee that utilizes funds to assist failing financial firms is “throwing good money after bad.”
White also stated that the Fed has aimed to raise the price of mortgage-backed securities (“MBS”) relative to other securities, and is in effect borrowing funds from commercial banks “in order to spend the proceeds, bidding up the price of MBS.”
In his testimony, Bivens said that the Fed has acted consistently in recent years in its attempt to achieve price stability and maximum employment. While acknowledging that the Fed’s conduct since 2008 has differed vastly from its past behavior, “that is simply a reflection of the extraordinary economic environment created by the Great Recession and resulting financial crisis.”
The Fed’s purchase of Agency bonds and MBS has helped the housing finance section, Bivens argued, and this increases the Fed’s impact in increasing economic activity and employment.
Finally, Bivens said that although regulations instituted since 2008 have encouraged financial institutions to hold a large share of U.S. debt, “that’s an appropriate response to the financial crisis of 2008,” because a driver of the crisis was that bank-held assets ended up being far less liquid than expected.
Question and Answer
Campbell stated that lawmakers see the Fed ranging into credit policy and credit allocation, and asked if this was “incompatible” with or threatened the agency’s independence.
White answered that some Fed officials suggest that criticizing the Fed’s lending decisions challenges its independence, but that it does not challenge the Fed’s ability to conduct monetary policy.
Clay asked Bivens how further empowering the influence of regional banks affects policy outcomes in Federal Open Market Committee (“FOMC”) decision making.
Bivens responded that the Board of Governors has had more aggressive voting records, which was the “appropriate way to go.”
Clay then asked how further empowering regional banks would influence the Fed’s focus on the employment part of dual mandate.
Bivens answered that regional bank presidents are more concerned with price stability, which is the wrong part of the mandate, adding that the maximum employment mandate was the correct part. The financial sector, he said, has interest with low rates of inflation that conflicts with maximum employment.
Clay asked how additional spending might impact a short-term and medium-term macroeconomic outlook.
Bivens explained that demand is too low, and in order to reduce the gap between supply and demand, “we need more spending.” He added that extending unemployment insurance would provide such an economic boost.
Huizenga asked Bivens if he agreed that the lack of government growth is why the economic recovery has been so slow; to which Bivens agreed.
Bivens added that if the government had doubled the levels of stimulus spending, interest rates would be higher as they reached a full recovery. White and Goodfriend disagreed.
Rep. Bill Foster (D-Ill.) commented that during the financial collapse and accommodation in response to the collapse, runaway inflation was predicted, and asked why these predictions were wrong.
Goodfriend explained that when the Fed dumped reserves into the system, there was a zero opportunity cost of holding reserves, which was something that had not been seen before, adding that “banks just held the reserves.”
White added that it was thought that high inflation was coming due to the doubling and tripling of the monetary base.
Bivens continued that inflation remains low despite these predictions due to the overestimation of how quickly the economy would recover, adding that the gap between supply and demand in the economy today is why prices remain low.
Foster then asked if the massive intervention in the housing market and mortgage-backed securities had the effect of “flattening out” housing prices.
Goodfriend answered that subsidizing credit towards housing takes credit away from other sectors. He noted that if current housing policy continues, credit will be drained from sectors where more productive capital could be obtained.
Kupiec added that while building houses adds to GDP, it is not a good that can be traded.
Rep. Stevan Pearce (R-N.M.) asked what would happen if the U.S. dollar was removed as the world’s reserve currency.
Goodfriend replied that the holdings of dollar-denominated securities abroad would be returned to the U.S., causing “big depreciation” against the dollar, creating inflation at home.
Kupiec added that the U.S. benefits from having reserve currency status.
White stated that there would be danger in that the exchange value of the dollar would collapse.
Bivens countered that the dollar’s reserve status actually hurts the country, as it keeps the dollar too strong. He explained that the dollar is “too strong to balance our trade,” but if the dollar were no longer the world’s reserve currency, import prices would increase.
Rep. Daniel Kildee (D-Mich.) asked Bivens what steps the Fed should take to promote economic growth and development.
Bivens stated that the best thing the Fed could do is to focus on the aggregate national labor market. He added that support should not be withdrawn from boosting support and economic activity until full employment is reached, and that the Fed’s decision to taper purchases is “worrisome” because it is premature. Bivens then said that the Fed did not have good tools for targeting pockets of distress when the “overall economy is doing pretty well.”
Rep. Mick Mulvaney (R-S.C.) asked what would happen if the Fed was not providing quantitative easing.
Goodfriend answered that “the Fed could stop quantitative easing tomorrow.”
Bivens added that it would have “modest effects” in the short- and long-term, and that “long-term rates are low because the economy is so weak.”
Mulvaney said that the Fed is using monetary tools to effectuate fiscal policy. Bivens disagreed, saying that the Fed is exercising fiscal policy in this circumstance.
White added that the Fed is not issuing bonds, but rather paying interest on bank reserves, and that it is a different way of borrowing money.
Rep. Robert Pittenger (R-N.C.) asked Kupiec what his concerns were regarding the qualified mortgage rule.
Kupiec explained that the rule imposes a model-based approach to underwriting mortgages, and since small community banks use their personal relationships with customers to obtain loans, this model-driven approach to lending would have a negative impact on them. He added that these approaches create an extra expense that small markets are not able to cover, forcing small banks from the mortgage market.
Kupiec then touched on the “new phenomenon” where Fed banking regulators are stopping some banks from making syndicated loans on the premise that they are part of a “credit bubble” that is fueling high-yield mutual funds.
Foster concluded the questions by asking the panel what they thought about businesses having to stay “well-capitalized” if housing prices went back to where they were previously, and also asked what an appropriate level of public disclosure would be.
“The more, the better,” said Bivens, adding that he wants to see more transparency in stress models.
White explained that it is important for banks to get the incentives right in order to accurately account for the risks they are taking in portfolio decisions, adding that “we don’t want to put unrealistic values in their portfolio.”
Kupiec replied that regional housing prices do not follow the same path as national housing prices do, and therefore banks have to translate the path to their own area, adding that “it’s a guess how prices are going to change.” He concluded that while transparency is a first step, “it’s imposing government regulator’s views on business decisions that should be the banks’ in the areas.”
For more information on this hearing and to view a webcast, please click here.
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At the March 12th House Financial Services Subcommittee on Monetary Policy and Trade hearing, lawmakers examined the central bank’s role in credit allocation.
Witnesses at the hearing included: Dr. Marvin Goodfriend, Professor of Economics at Carnegie-Mellon University’s Tepper School of Business; Dr. Paul Kupiec, Resident Scholar at American Enterprise Institute; Dr. Lawrence White, Professor of Economics at George Mason University; and Dr. Josh Bivens, Research and Policy Director at the Economic Policy Institute.
Opening remarks
In his opening remarks, Chairman John Campbell (R-Calif.) expressed that he wanted to examine the idea of quantitative easing (“QE”) and interest rates through the scope of both the Federal Reserve’s (Fed) current and past actions.
Ranking Member William Clay (D-Mo.) stated that the Fed’s balance sheet has expanded from $75 billion to $85 billion due to evidence that the economy is improving and improvement in the labor market. He further stated that one of the most affected markets in the 2009 financial crisis was the housing market due to employment and wage levels.
Vice Chairman Bill Huizenga (R-Mich.) expressed that he wanted to see what the spending in QE 2, QE 3 and twist accomplished, and the effectiveness of the Fed’s efforts to stimulate the economy. He expressed a concern with the Fed’s encroachment into fiscal policy through credit allocation, which breaks down historical safeguards in its independence from the federal government.
Witnesses Testimony
In his testimony, Goodfriend stated that “credit policy has no effect on the general level of interest rates because it doesn’t change aggregate bank reserves or interest paid on reserves. Credit policy is debt-financed fiscal policy.”
In the long-term, Goodfriend continued, a departure from a “treasuries only” asset acquisition policy does not comply with Fed independence. Additionally, he said, the Fed should utilize “treasuries only” aside from occasional, temporary, and well-collateralized last resort lending to solvent, supervised depository institutions.
Lastly, Goodfriend said Fed credit initiatives beyond a last resort lending should occur only with prior agreement of fiscal authorities and only as bridge loans accompanied by take-outs arranged and guaranteed in advance by the fiscal authorities.
In his testimony, Kupiec argued that it was government policies that supported the housing bubble, leading to the financial crisis. The same policies, he said, are in place today along with new programs to stimulate mortgage borrowing.
Further, Kupiec said, “Volcker Rule restrictions on collateralized loan obligations will impose significant costs on banks with no measurable gain in bank safety or soundness. The Rule should be amended without delay to allow banks to retain their legacy CLOs.”
Another issue, Kupiec stated, is that the Fed can fail a bank in the Dodd-Frank mandatory stress test without providing any evidence that the bank is at risk. He also raised the issue of community banks, which he says have stopped offering customer mortgages due to the new mortgage orientation rules.
Kupiec said that another concern is that the Dodd-Frank Act granted financial regulators the ability to prevent “systemic risk” without a definition what entails systemic risk, which in turn expands the power of the regulating bodies.
In his testimony, White described the Fed’s attempts to direct the allocation of credit as “overreaching, wasteful, and fraught with serious governance problems.”
White said that the central bank has been charged with five tasks: the clearing and settlement of checks, issue of paper currency, supervision and regulation of commercial banks, “lender of last resort,” and monetary policy. The Fed’s implementation of credit allocation policies does not fit into any of its five tasks, White said.
The programs the Fed implemented under its credit policies, White said, “are more likely than not to have been wasteful” and to negatively impact potential users of funds who have credit diverted away from them.
White stressed that a committee that utilizes funds to assist failing financial firms is “throwing good money after bad.”
White also stated that the Fed has aimed to raise the price of mortgage-backed securities (“MBS”) relative to other securities, and is in effect borrowing funds from commercial banks “in order to spend the proceeds, bidding up the price of MBS.”
In his testimony, Bivens said that the Fed has acted consistently in recent years in its attempt to achieve price stability and maximum employment. While acknowledging that the Fed’s conduct since 2008 has differed vastly from its past behavior, “that is simply a reflection of the extraordinary economic environment created by the Great Recession and resulting financial crisis.”
The Fed’s purchase of Agency bonds and MBS has helped the housing finance section, Bivens argued, and this increases the Fed’s impact in increasing economic activity and employment.
Finally, Bivens said that although regulations instituted since 2008 have encouraged financial institutions to hold a large share of U.S. debt, “that’s an appropriate response to the financial crisis of 2008,” because a driver of the crisis was that bank-held assets ended up being far less liquid than expected.
Question and Answer
Campbell stated that lawmakers see the Fed ranging into credit policy and credit allocation, and asked if this was “incompatible” with or threatened the agency’s independence.
White answered that some Fed officials suggest that criticizing the Fed’s lending decisions challenges its independence, but that it does not challenge the Fed’s ability to conduct monetary policy.
Clay asked Bivens how further empowering the influence of regional banks affects policy outcomes in Federal Open Market Committee (“FOMC”) decision making.
Bivens responded that the Board of Governors has had more aggressive voting records, which was the “appropriate way to go.”
Clay then asked how further empowering regional banks would influence the Fed’s focus on the employment part of dual mandate.
Bivens answered that regional bank presidents are more concerned with price stability, which is the wrong part of the mandate, adding that the maximum employment mandate was the correct part. The financial sector, he said, has interest with low rates of inflation that conflicts with maximum employment.
Clay asked how additional spending might impact a short-term and medium-term macroeconomic outlook.
Bivens explained that demand is too low, and in order to reduce the gap between supply and demand, “we need more spending.” He added that extending unemployment insurance would provide such an economic boost.
Huizenga asked Bivens if he agreed that the lack of government growth is why the economic recovery has been so slow; to which Bivens agreed.
Bivens added that if the government had doubled the levels of stimulus spending, interest rates would be higher as they reached a full recovery. White and Goodfriend disagreed.
Rep. Bill Foster (D-Ill.) commented that during the financial collapse and accommodation in response to the collapse, runaway inflation was predicted, and asked why these predictions were wrong.
Goodfriend explained that when the Fed dumped reserves into the system, there was a zero opportunity cost of holding reserves, which was something that had not been seen before, adding that “banks just held the reserves.”
White added that it was thought that high inflation was coming due to the doubling and tripling of the monetary base.
Bivens continued that inflation remains low despite these predictions due to the overestimation of how quickly the economy would recover, adding that the gap between supply and demand in the economy today is why prices remain low.
Foster then asked if the massive intervention in the housing market and mortgage-backed securities had the effect of “flattening out” housing prices.
Goodfriend answered that subsidizing credit towards housing takes credit away from other sectors. He noted that if current housing policy continues, credit will be drained from sectors where more productive capital could be obtained.
Kupiec added that while building houses adds to GDP, it is not a good that can be traded.
Rep. Stevan Pearce (R-N.M.) asked what would happen if the U.S. dollar was removed as the world’s reserve currency.
Goodfriend replied that the holdings of dollar-denominated securities abroad would be returned to the U.S., causing “big depreciation” against the dollar, creating inflation at home.
Kupiec added that the U.S. benefits from having reserve currency status.
White stated that there would be danger in that the exchange value of the dollar would collapse.
Bivens countered that the dollar’s reserve status actually hurts the country, as it keeps the dollar too strong. He explained that the dollar is “too strong to balance our trade,” but if the dollar were no longer the world’s reserve currency, import prices would increase.
Rep. Daniel Kildee (D-Mich.) asked Bivens what steps the Fed should take to promote economic growth and development.
Bivens stated that the best thing the Fed could do is to focus on the aggregate national labor market. He added that support should not be withdrawn from boosting support and economic activity until full employment is reached, and that the Fed’s decision to taper purchases is “worrisome” because it is premature. Bivens then said that the Fed did not have good tools for targeting pockets of distress when the “overall economy is doing pretty well.”
Rep. Mick Mulvaney (R-S.C.) asked what would happen if the Fed was not providing quantitative easing.
Goodfriend answered that “the Fed could stop quantitative easing tomorrow.”
Bivens added that it would have “modest effects” in the short- and long-term, and that “long-term rates are low because the economy is so weak.”
Mulvaney said that the Fed is using monetary tools to effectuate fiscal policy. Bivens disagreed, saying that the Fed is exercising fiscal policy in this circumstance.
White added that the Fed is not issuing bonds, but rather paying interest on bank reserves, and that it is a different way of borrowing money.
Rep. Robert Pittenger (R-N.C.) asked Kupiec what his concerns were regarding the qualified mortgage rule.
Kupiec explained that the rule imposes a model-based approach to underwriting mortgages, and since small community banks use their personal relationships with customers to obtain loans, this model-driven approach to lending would have a negative impact on them. He added that these approaches create an extra expense that small markets are not able to cover, forcing small banks from the mortgage market.
Kupiec then touched on the “new phenomenon” where Fed banking regulators are stopping some banks from making syndicated loans on the premise that they are part of a “credit bubble” that is fueling high-yield mutual funds.
Foster concluded the questions by asking the panel what they thought about businesses having to stay “well-capitalized” if housing prices went back to where they were previously, and also asked what an appropriate level of public disclosure would be.
“The more, the better,” said Bivens, adding that he wants to see more transparency in stress models.
White explained that it is important for banks to get the incentives right in order to accurately account for the risks they are taking in portfolio decisions, adding that “we don’t want to put unrealistic values in their portfolio.”
Kupiec replied that regional housing prices do not follow the same path as national housing prices do, and therefore banks have to translate the path to their own area, adding that “it’s a guess how prices are going to change.” He concluded that while transparency is a first step, “it’s imposing government regulator’s views on business decisions that should be the banks’ in the areas.”
For more information on this hearing and to view a webcast, please click here.