July 8, 2013

The Fed's Unhealthy Influence

Hester Peirce

Former Senior Research Fellow
Summary

A few weeks ago, markets reacted very badly to the Federal Reserve's announcement that it would have to stop its bond buying spree at some point, and indeed might, in Chairman Ben Bernanke's words, "moderate the monthly pace of purchases later this year." The market's response prompted Fed officials to tell market players to collect themselves and stop behaving like "feral hogs," which apparently are pretty dogged in pursuing something once they get a whiff of it.

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A few weeks ago, markets reacted very badly to the Federal Reserve's announcement that it would have to stop its bond buying spree at some point, and indeed might, in Chairman Ben Bernanke's words, "moderate the monthly pace of purchases later this year." The market's response prompted Fed officials to tell market players to collect themselves and stop behaving like "feral hogs," which apparently are pretty dogged in pursuing something once they get a whiff of it.

But hypersensitivity to Fed pronouncements is natural when the Fed, through its monetary (and arguably fiscal) policy, is such a huge player in the marketplace. The Fed also plays a huge role in shaping the marketplace through its regulatory policy.

Last week, for instance, it announced the new Basel III capital rules for banks. These rules are supposed to make banks stronger and less vulnerable to severe market downturns. They are known as "Basel" rules, because they are based on a framework agreed to by central bankers in meetings that take place in Basel, Switzerland. The III in "Basel III" means that they replace prior iterations of bank capital standards, which, as the last financial crisis illustrated, have not worked terribly well.

The thousand-page rulemaking includes updated risk-based capital rules. To finance its business, a bank needs money, which it can get by retaining the money it earns, raising money by selling shares or borrowing money. When you deposit money with a bank, the bank is borrowing from you, but banks can also borrow from other financial institutions. If the bank does well, depositors and other creditors get paid back, and the shareholders get to keep the profits. If the bank runs into trouble, depositors and other creditors are supposed to get paid back before shareholders get a dime. 

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