In this analysis, Tom Hibbert. multi asset strategist, Canaccord Wealth, explores US Treasury Secretary Scott Bessent’s warning that the Fed’s post-GFC policy experiments have created lasting distortions, fuelled inequality, and left the central bank’s independence under threat, just as rate cuts return to the agenda.
A ‘gain of function’ is when something, often a gene, or virus, acquires a new ability it did not have before. In the lab, that can mean deliberately altering pathogens to infect more easily, replicate faster, or resist treatment. The upside is scientific insight. The downside is a potential pandemic.
Treasury Secretary, Scott Bessent, has just published a paper titled ‘The Fed’s New ‘Gain-of-Function’ Monetary Policy’. It is prescient not only because this is Fed week, but because it explains the roots of the administration’s assault on its central bank.
Bessent argues that “overuse of nonstandard policies, mission creep, and institutional bloat” unleashed after the Global Financial Crisis (GFC) – most notably the vast experiment with asset purchase programmes (QE) and ultra-low rates – produced distortions and unintended consequences that now threaten the Fed’s independence.
In 1991, Kansas City Fed President Thomas Hoenig urged monetary policy to be conducted with restraint and humility, because of the long-run consequences of their policy decisions. During the GFC, policymakers abandoned that principle, convinced their new tools could steer the economy. It was then that they became the ‘Lords of easy money’.
The problem is that the toolkit was neither well understood nor properly tested. Ben Bernanke, Fed Chair during the crisis, admitted as much in 2014: “the problem with quantitative easing is it works in practice, but it doesn’t work in theory.”
Through QE the Fed replaced relatively illiquid government debt with liquid cash, monetising national debt and injecting liquidity into the financial system. At the same time, it drove bond yields lower, forcing investors into riskier assets and inflating their prices. The Fed’s balance sheet has ballooned from $900bn pre GFC to peak at $9tn in 2021 – the gap being the scale of debt monetisation (money printed).
The ‘shadow Fed Funds rate’ which adjusts for these unconventional policies, fell as low as -3% in 2014. Yet despite this ultra-loose stance, there is little evidence of any lasting productivity boost. What there is clear evidence of is asset inflation. Bessent highlights a 2017 paper that found QE’s effect on equity prices was ten times greater than its impact on real economic output.
The wealth imbalance
This asymmetry has disproportionately benefitted asset owners while subsequent inflation and higher borrowing costs have disproportionately affected lower income cohorts and smaller companies. The asymmetric distributional wealth effect has contributed to the vast inequality now tearing at the social fabric of Western societies.
‘Progressive financial policy expert’ Karen Petrou wrote that “unprecedented inequality, is clear proof that the wealth effect”… referring to the Fed’s policies “is all too effective for the wealthy, but an accelerant to economic hardship for everyone else”. Petrou also points out that the Fed’s persistence to rescue the financial system at the first sign of crisis – what investors call the ‘Fed put’ – has created an environment of “socialism for investors, capitalism for everyone else”.
Secretary Bessent argues that as well as straying from their limited mandate, pursuing unwarranted, unprecedented strategies and making numerous policy errors while doing so, the Fed has also become increasingly partisan with the distribution of political donations favouring Democrats. He alleges that the Fed has overestimated its ability to drive growth and control inflation and that their political biases have overestimated the efficacy of government spending and underestimated the efficacy of tax cuts and deregulation – implying that their political biases have created flaws in their models.
Is it possible to control inflation? No…
One example of overestimating their own influence was the Fed’s ‘transitory narrative in 2021, or what former Bank of England Governor, Mervyn King, coined the ‘King Kanute’ (who believed he could control the tides with his words) theory of inflation – where the Fed stated that inflation expectations were a key factor in fuelling inflation and that the Fed signalling their commitment to low inflation would be enough to contain it. As King said, “A satisfactory theory of inflation cannot take the form, ‘inflation will remain low just because we say it will’.”
Bessent concludes that the Fed’s actions since the GFC have “eroded the institutions insulation from political pressure” and threatened its independence. Pointing to the “potentially dire” long-term consequences, he calls on the central bank to scale back their pursuit of unconventional policies and for an independent and nonpartisan review of all their activities.
The Fed is very likely to resume rate cuts this week. But as Bessent makes clear, the Fed’s position is now considerably more complex. There is much more to monetary policy than interest rates; the imminent decision for the next chairman, efforts to oust Governor Lisa Cook and to manoeuvre Stephen Miran onto the FOMC highlight how contested the institution has become.
