This is the Biggest Political Decision Of 2013 That Nobody is Talking About

In the coming days, President Obama will select a new Federal Reserve Board Chairman to succeed Ben Bernanke, a major political decision that has mostly flown under the radar in the media and on social networks.

In normal times, this appointment by the president would be an important moment, but considering the Fed's current impact on the economy, the selection of the right person is even more critical. Will the new Fed Chairman continue the Bernanke strategy to revitalize the economy, or will he or she change course? All this will be fleshed out during the Senate approval process. Anyone who intends to follow the proceedings should be familiar with the recent actions by the Fed, especially those taken since the Great Recession economic slump which stated in December 2007.

Ever since President Obama said Federal Reserve Chairman Ben Bernanke has been at his post “longer than he wanted,” econ wonks have fiercely debated who should take his place; Bernanke’s term expires on Jan. 31 of next year. Former Treasury Secretary Larry Summers and Janet Yellen, the vice chairwoman of the Fed’s board of governors, lead the field of contenders, but Summers has proved to be a controversial option. The Roosevelt Institute describes what’s at stake in picking the next Fed chair: Whoever takes over for Bernanke will be in charge of rebuilding the economy after the Great Recession.

Many of the things instituted by the Bernanke Board — Quantitative Easing, low interest rates, sluggish employment numbers, and even the strategy of bank bailouts — will need to be reconsidered as the economy improves. Understanding this history up to this point will be critical.

In June 2007, the Fed had total assets of $900 billion. Over the next five years, this amount nearly quadrupled to $3.3 trillion.

In 2007, Treasury securities were 88% of the total assets. Shortly after, over the next 10 months, the Fed purchased $1.1 trillion of other securities in an effort to increase the money supply and spur the economy; the latter would hopefully increase jobs creation (it did not materially).

Correspondingly, currency in circulation of $810 billion, which was 90% of liabilities plus capital ballooned to $1.2 trillion, as people generally would rather have cash during difficult times.

Equally important, bank reserves increased dramatically from $45 billion to $1.9 trillion as many banks became defensive and liquefied their balance sheets keeping cash at the Fed. These funds rose as banks sharply reduced the amount of loans they were extending to companies and individuals. Ironically, this action ran counter to what the Fed was trying to accomplish, which was to increase the amount of cash in the hands of consumers.

The Fed was created in 1913 during the Wilson presidency. Its central mission is to deter depositor runs that would threaten the banking system. When depositors lost confidence in a bank, they would demand their money in cash. To meet this demand, banks would have to sell assets quickly, sometimes at large losses, to satisfy depositors. Many banks defaulted and were forced out of business as the losses were too great to overcome.

The Fed made depositors more secure, as it stood ready to lend cash to solvent but illiquid banks. The system worked well until the stock market crash in 1929-1930. The Fed continued to defend solvent banks but was remiss in not providing more liquidity through its "open market" operations. It did not expand the money supply while under the false impression that real rates were already low enough. If the Fed had been more aggressive and purchased bonds from banks, the money supply would have increased further and could have offset deflation, the principal reason for the Great Depression.

Similarly, our current short-term nominal rates seem low and are near zero. This does not excuse the Fed from taking further other actions to increase trade and drive up employment. The Fed wisely has continued to purchase bonds to ensure that the money supply grows sufficiently to contain deflationary pressures.

When the recent recession geared up, the Fed was intent on stemming the tide of economic paralysis and deflation. In August 2007, the Fed cut the federal funds rate (the rate at which banks borrow from each other). At the same time, the Fed provided several credit facilities to assist bond market players, and issuers of commercial paper that were hampered by the Lehman Brothers bankruptcy. These accommodations were very beneficial and ultimately did not cost taxpayers anything.

By the end of 2008, the Fed drove down the federal funds rate to near zero, and it no longer had any ability to stimulate the economy with further reductions. At this point, Quantitative Easing (QE) began. Simply, the Fed purchased various types of securities from banks to increase the money supply. The objective was to increase the amount of liquidity in the system, which would ultimately serve to increase employment. Unfortunately, banks continued to hoard reserves and offset the impact of quantitative easing. The Fed was intent on maintaining this program until the liquidity flowed into the economic system, and by December 2012 it held $2.7 trillion of securities acquired through QE1 and QE2.

The Fed thought it necessary to provide more information about its objectives. In January 2012, it announced a 2% inflation target and an unemployment target of 5.2-6.0% (this was amended to 6.5% later). This meant that so long as inflation was low (it is still substantially below the target at this time), and unemployment was above the target (it is), the Fed would continue to buy bonds from banks and further increase the money supply.

An issue mentioned earlier continues to impact the Fed's actions: banks have not increased their loan portfolios significantly to this point resulting in a markedly lower velocity of money.

This phenomenon occurred because of continued bank reservations about the economy and credit losses along with a program instituted by the Fed to pay interest on the reserves kept at the bank.

Moving forward, the Fed and the new Chairman will have a very important role. Many of the things instituted by the Bernanke Board will need to be reconsidered as the economy improves. They include, but are not limited to selling several trillion dollars of bonds without driving up interest rates too high, monitoring inflation and hitting the 2% target, increasing employment, etc. The job of the new Chairman is daunting to say the least.

Note: My guide to the time line to be presented herein will be an article titled "The Fed's Rough Road Ahead" by James R. Barth and Apanard (Penny) Prabha, published by the Milken Institute.