Are the Fed and the Treasury in cahoots?

BY Catherine Mann  December 20, 2013 at 10:32 AM EDT

Why is one arm of the government buying loans from another? The U.S. government isn’t a monolith, former Fed economist Catherine Mann explains, and the Fed is often a counterweight to what’s happening in the rest of the government. Photo illustration courtesy of Flickr user Donkey Hotey.

It’s been a big week for the Fed. On Monday, the central bank celebrated its centennial. On Tuesday, the Fed’s Open Market Committee commenced a two-day meeting to decide whether to wind down their monetary stimulus program. And on Wednesday, Fed chair Ben Bernanke gave what could have been his final press conference, explaining the committee’s decision to taper the Fed’s purchase of mortgage-backed securities and Treasuries by $5 billion each.

Having been center stage all week, the Fed’s waiting to see when Congress will approve their new chair. In an effort to limit debate time on Janet Yellen’s confirmation vote, Senate Majority Leader Harry Reid, D-Nev., reportedly met with Sen. Rand Paul, R-Ky., who had threatened to debate her confirmation for the maximum 30 hours unless the Senate considered a bill to publicly audit the Fed’s operations. The Senate is now expected to confirm Yellen when they return from recess in January.

The delay in approving Yellen is a recent, even if fairly innocuous, example of how holdups in other parts of Washington impact the Fed. Congress’ intransigence has been a repeated headache for the Federal Reserve, but the recently struck bipartisan budget deal may have given the FOMC more latitude than they had in September, for example, when talk of a debt ceiling default and government shutdown were eating away at economic confidence.

To explain more about how the Fed interacts with its Washington neighbors, from the U.S. Treasury to Capitol Hill, here is the last of our extended conversations with former Fed economist Catherine Mann, whom we’ve also spoken to about banks redepositing Fed stimulus back at the Fed and about how quantitative easing has increased the flow of dollars abroad.

Paul Solman: People I know, very sophisticated people, think it’s nuts that one arm of the government, the Federal Reserve, is buying loans that are issued by another part of the government, the U.S. Treasury. What’s the defense of that, the left hand buys from the right hand?

Catherine Mann: Well the objective of the Federal Reserve is sustained long term growth, 2 percent inflation, unemployment below 6.5 percent and positive and robust GDP growth. The means by which we get there is by having lower interest rates. Regionally, what the Federal Reserve does most of the time, up until 2008 anyway, is to focus on just the very short-term interest rate that banks borrow from each other, the Fed funds rate. That is still what they control, but they’ve also used quantitative easing to bring down long-term interest rates.

The other part of the government, which is the one that’s issuing the bonds — well, the Fed doesn’t have any role to play in terms of the taxing decisions, the expenditure decisions, the budgetary disagreements. If the government is helping the Fed, if the fiscal climate and the politicians are either helping or hurting, [the Fed] responds to the consequences. The Federal Reserve has to look at the economy’s behavior and act accordingly.

Paul Solman: So the Federal Reserve, in that sense, is a counterweight to what’s happening in the government?

Catherine Mann: Let’s go back to the September Federal Open Market Committee meeting. A number of people expected at the September meeting for the tapering to start. At that point, the August numbers had been looking pretty good and so the sense was September would be a good time to start tapering. Of course, in the end, they did not taper. There are lots of theories about why, but my view going into that was that the probability of a debt ceiling debate was very high — it was already starting, with negative consequences for the economy — and a shutdown [was also probable]. We can look in the historical data for what happens to consumer behavior, to business behavior: consumers stop spending, businesses don’t invest when they think the government, the fiscal side, the politicians are going to have a big fight about the debt ceiling, maybe even default. And the consequences for the economy of a shutdown — people were talking about, is it going be a half a percentage point on GDP, it might even be 1.5 percentage points on GDP…

Paul Solman: Shrinkage.

Catherine Mann: Shrinking as a consequence of these shenanigans going on between the Republicans and the Democrats. So the Federal Reserve in September, looking at the economy going forward, beyond their FOMC meeting, [asked,] “Do we want to add the negative consequences of potentially higher interest rates that would come from the tapering?” And so the decision was, “We don’t want to add more fuel to the shrinking of the economy that we’re already getting from what’s going on with the debt ceiling debate, the continuation of the sequester, the shutdown…”

Paul Solman: So it’s foolish to think of this being just one government — the United States government. These are two completely separate parts of the government, you’re saying?

Catherine Mann: These are two completely separate parts of the government, and the Federal Reserve has to be responsive to what the consequences for the economy are of what happens in the other side in Washington… well, further down Constitution Avenue, under the big dome.

How does the Fed reach their policy decisions? Paul Solman simulated a meeting of the Fed’s Open Market Committee to find out.

This entry is cross-posted on the Making Sen$e page, where correspondent Paul Solman answers your economic and business questions