What the Fed Has Become

Reflections from Rubin and Volcker before we hear Bernanke's take on central banking in the U.S.

The version of the $500 bill that featured President William McKinley was issued by the Fed in 1934. It was previously issued as a gold certificate in 1928. (Wikimedia Commons)

Ben Bernanke is set to make a speech about the history of the Federal Reserve and central banking on Wednesday afternoon, and if the past is a good predictor, his comments could move markets. Reflections from former treasury secretary Robert Rubin and former Federal Reserve chairman Paul Volcker might give an early hint: The Fed has changed. The institution was originally created in 1913 to be a source of last-resort cash for banks in financial panics and maximize employment, stabilize prices, and moderate long-term interest rates. Since then, Volcker and Rubin say, the Fed has become a bigger part of policymaking, especially in economic downturns.

Paul Volcker, who served as Chairman of the Federal Reserve from 1979 to 1987, spoke with Atlantic editor in chief James Bennet at the Economy Summit in March. Here's what he had to say (lightly edited for length).

"Obviously, the Federal Reserve has come to play and extraordinary role in maintaining the economic recovery. In doing so, it stepped out of the long-established but more limited institutional role of a central bank.


Instead of confining its operations to intervention in the money markets and control the bank reserves; the tension is today directed toward massive support, directly and indirectly, of capital markets, and most particularly, the market for residential mortgages.

What it amounts to is that the Fed has become the principal intermediator in American financial markets. In the common vernacular, that is termed, 'printing money.'"

But when a lot of that "printed money" gets directly injected into the economy through a process known as quantitative or monetary easing, he said, that could create problems, including widespread speculation.

"Indeed, extreme monetary easing, with the suggestion that the approach will continue indefinitely, could encourage elements of speculative activity, undermining the very process of restored sustainable growth and financial stability. I make that point because I believe that the Federal Reserve or any central bank must not minimize or neglect its responsibilities for oversight of the financial system as it devotes attention to the conduct of monetary policy."

Robert Rubin, who served as Secretary of the Treasury from 1995 to 1999, has also commented on the situation facing the Fed because of its recent policies. Here's what he said at the Aspen Ideas Festival this month. "QE1" and "QE3" refer to two recent cycles quantitative easing, which aimed to lower interest rates and encourage banks to lend more money.

"I think the question of where we are in terms of Federal Reserve policy is actually a very difficult one. I think QE1 was absolutely critical to getting off the abyss. I think QE3 is a much more difficult judgment to make. Surely commentators say that the justification for QE3 was the fact that our political process wasn't working. But the right question was: What are the benefits going to be and what are the risks going to be? I think most analysts think the benefits have been somewhat limited, probably. But I think the risks are quite real. There is a moral hazard risk to our political system, and even if the bond market wasn't much affected, there's a broadly held view that as you go out the risk spectrum, it's contributed to excesses, because there's a comfort level that the Fed will continue in its current mode.


"The big risk, the important risk, the one that affects all of us, is: How are we going to get out of this thing? They have an unprecedented size of balance sheet, they have unprecedented monetary conditions, and it's always very difficult for the Fed to figure out how to deal with rates. Now they're going to have to do it with conditions that are unprecedented, and I think that creates enormous uncertainties."

If the above assessments are accurate, Rubin's final question is key: What happens now? Will it be possible for the Fed to continue playing a larger role in policymaking, or will it bow out as a leader in the economic recovery? We'll see what Bernanke has to say.