Fed faces challenges to credibility

The Federal Reserve is attempting to tamp down two significant challenges to its credibility as both its handling of inflation and internal ethics face growing scrutiny. 

The central bank is quickly moving to address a scandal involving stock trades made by its top officials. And price increases are running higher and longer than many Fed officials expected, boosting pressure on the bank to slam the brakes on the recovery from the COVID-19 pandemic and back down from a new, more tolerant approach to inflation. 

Both could have deep implications for the Fed as a whole, as well as for Fed Chairman Jerome Powell’s future at the institution.

Powell and other top bank officials have remained committed to the strategy they unveiled last year, despite inflation lingering at 30-year highs. They, along with a broad range of economists, argue that most of the pressure on prices is caused by supply chain disruptions and coronavirus-related constraints likely to pass along with the pandemic.

“We think we can be patient and allow the labor market to heal,” Powell said Friday in remarks at a virtual conference, adding that “no one should doubt that we will use our tools to guide inflation back down” if it gets out of hand.

The Fed last year launched a strategy that allows inflation to rise above the bank’s 2 percent annual target to make up for almost a decade of low price increases and stagnant wages. The new framework was meant to allow wages and employment to rise until inflation was on track to average out near the Fed’s ideal level before the bank hiked interest rates.

Even so, the persistence of high inflation and uncertainty over how long it will last is boosting pressure on the Fed to change course and deviate from its new framework. 

Prices grew by 4.3 percent in the year leading into August, according to the personal consumption expenditures index, the Fed’s preferred gauge of inflation. The consumer price index for September also showed steady increases in food, energy and housing prices, prompting interest rates on bonds to rise as Wall Street braces for higher inflation. 

The Fed is almost certain to announce next month its plans to reduce its monthly purchases of Treasury and mortgage bonds, initiated in March 2020 to keep markets flowing, with the economy well into its recovery. Powell reiterated Friday that the Fed does not plan to raise interest rates until the labor market is on track to fully recover from the pandemic.

Announcing a sooner start to interest rate hikes could appease inflation hawks and soothe some concern about rising prices. But experts say it would raise serious doubts about the Fed’s willingness to follow its own rules as it also scrambles to contain the fallout of a trading scandal involving at least two former top officials. 

“They know they can’t do their job effectively if everyone’s questioning their motives,” said David Beckworth, a senior research fellow at the libertarian-leaning Mercatus Center. 

“The biggest point of this trading scandal is it undermines the Fed’s independence,” he continued. “If your independence is undermined by people in Congress or by critics outside looking in, then it’s harder to be that technocrat who says, ‘Look, it’s not time to tighten and we’re going to cause more harm than good if we do.’ ”

The trading scandal erupted in September when reporters revealed heavy trading activity by former Dallas Fed President Robert Kaplan and former Boston Fed President Eric Rosengren in 2020 — when the central bank deployed trillions of dollars to stabilize financial markets and shield the economy from COVID-19. While the Fed said the trades made by Kaplan and Rosengren were in line with each reserve bank’s rules, they both stepped down from their posts, and the incident prompted a broader review of Fed standards.

The disclosure of Fed Vice Chairman Richard Clarida’s sale of a stake in a stock fund and subsequent purchase into a bond fund in February 2020 also fueled more scrutiny of the bank.  Though some ethics experts say Clarida’s purchase raises fewer red flags than Kaplan’s and Rosengren’s trading of individual securities, the episode raised concerns about the Fed’s intentions as it defends maintaining loose financial conditions that incidentally support the stock market.

“Markets, households, businesses — they need to know that the Fed is going to do what they say they’re going to do, and they need to think that the Fed is going to work in the best interest of whatever is the public interest,” said Sarah Binder, a political science professor at George Washington University.

The Fed imposed Thursday strict new trading standards for Fed board members, reserve bank presidents and other senior officials with access to high-level information within a month of the outset of the scandal. While Beckworth and Binder said the Fed’s quick response was necessary to contain the fallout, both ceded that President Biden’s looming decision on Powell’s renomination could have played a role in expediting the release.

Powell’s four-year term as Fed chair expires in February, and Biden has not yet indicated whether he will renominate the top banker or replace him with a more liberal successor. While Powell is largely aligned with Biden on monetary policy and broadly popular on both sides of the aisle, the president faces growing pressure from the left to elevate Fed board member Lael Brainard, the only Democrat on the bank’s board, to the top role.

Powell was considered the front-runner for Biden’s nod before the trading scandal, and the Fed’s quick response may do little to change that. The president may also find it difficult to win support for Brainard or a more liberal choice in a 50-50 Senate, especially as Sen. Joe Manchin (D-W.Va.) calls on the Fed to tighten faster than it plans to at the moment.

Ian Katz, director at Washington research firm Capital Alpha Partners, said it’s possible that the scandal may have done nothing more than delay Biden’s decision to renominate Powell to a more palatable time. But Katz warned that if Biden has yet to make a decision, the fallout could shape the Fed in unforeseen ways. 

“If it’s really like a toss-up or something and they’re sitting there thinking about what to do, then this wouldn’t be helpful,” Katz said.