How the Fed can boost growth | Mint

How the Fed can boost growth

The Fed has monetary and regulatory powers that deeply influence growth. It needs to use them. (File Photo: Reuters)
The Fed has monetary and regulatory powers that deeply influence growth. It needs to use them. (File Photo: Reuters)

Summary

Shrink the balance sheet, stabilize the dollar, get capital flowing, and speak out about fiscal profligacy.

The U.S. is in a vulnerable position. Its military is stretched thin supplying the current wars and will take years to rebuild. The abrupt withdrawal from Afghanistan damaged America’s global reputation, making it difficult to galvanize opposition to Russia or Hamas via once-formidable American soft power. The U.S. is also struggling economically under an administration dominated by activist regulators and a badly broken budget process that contributes to the nation’s decline through high spending, taxes and debt. Long-term economic growth projections are below 2%.

There is, however, a bright spot. The recent peak in bond yields creates an opportunity for the Federal Reserve. It has monetary and regulatory powers that deeply influence growth. It needs to use them.

The Fed’s current strategy is to raise interest rates until growth and inflation fall. This “high for long" strategy risks causing permanent damage to growth by weakening private investment. With yields falling from their October peak, the dollar stable, and interest rates already at 5.5%, the Fed has an opportunity to make a fundamental shift in monetary and regulatory policy to encourage noninflationary growth and set the stage for rate cuts, not hikes. It should do four things:

First, shrink its balance sheet more quickly. It has already reduced its Treasury holdings by $1.2 trillion since the peak in May 2022. Economic growth has been resilient, reaching 4.9% in the third quarter of 2023. Paradoxically, reducing bonds is working better than buying bonds did. The Fed’s bond holdings aren’t needed. They are funded by bank debt, not money printing, which crowds out small businesses and pushes up commercial bank leverage ratios, constraining lending. Maintaining the bond holdings benefits government, big corporations and commercial real estate but slows growth. It has already caused hundreds of billions of dollars in losses for U.S. taxpayers. The Fed can cut its interest expense and take pressure off interest rates by allowing its bonds and bank debt to shrink rapidly and boost growth.

Second, the Fed should emphasize dollar stability to encourage investment and growth. Treasury sets dollar policy, but the Fed can easily make dollar stability more visible by incorporating the dollar into its inflation and growth models. Those models don’t work because they assume that growth causes inflation. They should reflect the importance of the dollar in achieving price stability.

Dollar stability is an urgent priority. The greenback is at risk from China’s yuan, the high national debt, overused sanctions, and crypto. China has an explicit “strong and stable" yuan policy that helps the currency through inflation and interest rates that are lower than in the U.S. A policy of peace through strength starts with confidence that the dollar will be strong and stable for decades to come.

Third, the Fed must allow capital to flow more freely for greater investment and dynamism. The Fed controls banks by setting requirements on risk-based capital, leverage and liquidity. The current mix is choking off innovation and small-business lending, compounding the crowding out from the Fed’s giant bank debt. Government regulators have made repeated mistakes, among them putting costly capital requirements on business loans but none on government, biasing capital to government. Regulators understated the risk of an interest-rate spike in stress testing and ignored the maturity mismatch and withdrawal risk at Silicon Valley Bank and others. Regulators blame banks when mistakes occur. The medicine—higher capital requirements—drives up costs and lowers growth more than it lowers risk.

Fourth, to guard its credibility and independence, the Fed needs to speak out on fiscal profligacy as Paul Volcker and Alan Greenspan did.

The Fed can help growth by reducing its bond holdings and bank debt, defending the dollar, and taking a deep breath before creating more layers of costly financial regulation. This would set the stage for faster growth and lower interest rates, a win-win.

Mr. Malpass served as president of the World Bank, 2019-23, and undersecretary of the U.S. Treasury, 2017-19.

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