Todd Suomela's Library tagged the-fed →  View Popular

So far, so good. Except, there's a hole. That hole is that the Fed hasn't followed the simple "Taylor rule." In fact, there's been a significant gap between Taylor rule and interest rates. Or more exactly, two of them.

The first was between 1994 and 1998 -- the Fed was consistently above the Taylor rule. This lead several more left-leaning economists to call for lower interest rates to get more growth. The second was between 2001 and 2008 - the Fed was consistently below the Taylor rule. What a coincidence. So the argument that the Fed was a transparent carrier of the economic demand for funds breaks down. The other point is that there is a simple explanation for all three - short term rates, inflation, and budget deficits moving in tandem over the last 10 years, namely that they represent the same thing, not a  market that is clearing, but three different forms of the same thing, namely, risk aversion.

Central bankers attempted to fix the problem, but they may have made it
worse. In the late '80s, the Fed and Wall Street leaders, joined by
foreign central banks, created an international regulatory regime that
requires banks to hold greater levels of capital instead of bank
reserves. Reserves are the Fed's traditional cushion for ensuring the
"safety and soundness" of the system. Banks were required to post
non-interest-bearing accounts on their balance sheets to backstop
deposits and as the means for the central bank to brake bank lending. It
was assumed that the new capital requirements would do the same.
Instead, the so-called Basel Accords (named for the Bank of
International Settlements in Basel, Switzerland) applied very little
restraint on lending but created an unintended vulnerability for
banking. The new rules have acted like a pro-cyclical force--driving
banks into a deeper hole as the crisis has spread because bank capital
is destroyed directly by the mounting losses from market securities. The
more banks lose on their rotten assets, the more capital they have to
borrow from wary investors, who understandably refuse to play. That
spreads the panic and failure that governments are trying to cure with
public money.

Meanwhile, acting at the behest of bankers, the Fed has practically
eliminated the old safety cushion by allowing reserve levels to fall
nearly to zero. Bankers complained that reserves were a drag on profits
and were no longer needed given the capital rules. In a shocking new
arrangement, the Fed, with approval from Congress, has started to pay
interest to the banks on their reserves. The commercial banks already
enjoyed privileges and protections from the government that were
unavailable to any other business sector. Now they insist on getting
paid for their public subsidy.