There are two fundamental issues with respect to the powers of the Federal Reserve that deserve attention; the "shouldn'ts and the "Can'ts." Following the most recent announcement of more quantitative easing there's been much debate concerning whether or not the Fed should do this. The decision to take this path was made 50 years ago and I encourage subscribers to read that column again.
QE will be pursued and expanded until the economy recovers or the Fed and perhaps Treasury are insolvent. There is no turning back and debating the issue is a waste of time and distraction from considering the consequences of the Fed's actions.
But once this is accepted, it leads to a discussion of what the Fed can't do. From a pragmatic standpoint there is no restriction on what the Fed can do -- which means there is nothing they can't do.
Until the financial crisis of 2008, the Fed's operating restrictions were considered to be limited by Section 14 of the Federal Reserve Act, which limits the Fed's balance sheet to gold and assets guaranteed by sovereign governments, largely interpreted to mean sovereign and agency debt with allowances for short-term obligations of U.S. municipal governments.
But there is failsafe to these restrictions, Section 13, which was amended on July 21, 2010 to allow the Fed unilateral broad powers to accept essentially any other kind of security in swap for Federal Reserve notes.
Section 13 is what allowed the Fed to accept AIG and Bear Stearns debt in what were known as the Maiden Lane Transactions, which have been accounted for as profitable for the U.S. Treasury as passed through to it by the Fed and originated as part of the TARP program.
The fact that these transactions are claimed to be profitable by the Treasury supplies practical political support for this kind of program to be used again in the future by the Fed even without Treasury participation as long as the Treasury Secretary approves.
This is important to understand given the fact that the Fed's most recent QE is targeted at agency debt; which is leading many to assume that the Fed can't begin to accept non-agency debt or other kinds of assets in swap for QE infusions.
If QE targeted at agency debt is deemed to be unsuccessful the Fed can, under the provisions of Section 13.3.A, determine that "unusual and exigent circumstances" exist, which allow it to accept any form of collateral.
I don't know if this will be required, but it is important for investors to be aware of this and stop thinking about what the limitations on the Fed are. For practical purposes there are none.
Roger Arnold is the chief economist for ALM Advisors, a Pasadena, Calif.-based money management firm specializing in income-generating portfolios. Concurrent with his other business responsibilities, Arnold was a radio talk show host for 15 years. He focuses on behavioral economics and chaos theory, better known as the "butterfly effect." He explains the relationships between political, economic and social systems, and how they are all reflected in the financial markets -- stocks, bonds, commodities, currencies and real estate.