The large and eclectic field of presidential contenders is in full-out campaign-promise mode, as voters demand positions on everything from ISIS to ethanol.  With the economy so fragile, now might be a good time to seek commitments on who our next president will appoint to the Federal Reserve, and statements on what the proper role of the Fed should be.

Recent history is too important to ignore. After the Fed lowered interest rates to zero during the recession, it found itself lacking options for further “stimulating” the economy. It therefore began what it called Quantitative Easing (QE), which works more or less as follows: A bank buys a treasury bond for $97 million. Assume this bond matures in one year, and will be repaid at $100 million, or (very roughly) a 3 percent annual interest rate.

ADVERTISEMENT

Under QE, the Fed creates new money. In our example, it will create $98 million, to buy this bond. By doing so, the interest rate has decreased to approximately 2 percent. And the bank made an easy profit, risk-free, on top of any commissions. But if the bank fails to lend out those funds, it does little for the economy.

You might ask yourself why the quasi-governmental Federal Reserve doesn't just buy bonds directly from the Treasury. “No,” they say, “that would be too close to just printing money for the government.” As if using a middleman and generating private profits makes the process significantly more palatable.

After easing for years, now the Fed seeks to raise rates. Of the available methods, it does not wish to force the government to repay loans, so it rolls over the bonds where possible. It also doesn't want to sell the bonds right back to the banks, which might make it appear they were “churning” – generating transactions to earn fees. And the Fed's typical pre-recession move – controlling the supply of money by soaking up bank reserves – would be ineffective now, since it created so much new money during the last decade.

So, what will the Fed do? It will offer interest to banks on the funds they hold on reserve. In other words, the Fed will pay banks to let their money stay put, instead of lending it to me and you. The percentages might seem small, but remember, this is risk-free profit, generated on vast sums. If you're questioning these actions – bidding up an asset that private parties own, paying them a commission to buy it, and then paying interest on the money you gave them – you're not alone.

Now that we've established that QE has profited banks, you might ask what it has done for the overall economy. Recently, certain economists have raised the possibility that it might have actually hurt it. Recall that conventional economics is often bad at predicting outcomes, like the extent that government spending (a theoretical stimulus) can “crowd out” private spending (and thus paradoxically hurt the economy) – or how the S&P downgrade of the United States' credit rating in August 2011 counterintuitively caused U.S. borrowing costs to decrease.

These contrarian economists seek to explain why decades of Japanese efforts to spark inflation have had the opposite effect, and why similar efforts in the U.S. largely failed to reflate anything besides the stock market. They wonder if the reduction of interest rates has had a counterintuitive result.

Conventionally, the "real" interest rate is the nominal (or common) interest rate, minus inflation. Therefore, if your bank pays you 5 percent on a CD, but inflation eats up 4 percent, your real interest rate is 1 percent. Similarly, if you borrow money at 7 percent, but inflation (and wages, investment returns, etc.) rise by 6 percent, then you're only really paying 1 percent on your loan. The contrarian economists theorize that real interest rates will always seek a certain level, independent of central-bank actions. Therefore, if the Fed depresses interest rates, inflation too will fall, to meet the real interest rate that the economy is pricing by itself. So if the Fed has driven down nominal interest rates to 1 percent, but the economy stubbornly sets a “real” interest rate of 1 percent, inflation will thus be zero.

I believe the real interest rate is more the result of a subtraction calculation, than an innate level on which one can base a re-arranged equation. But one wonders if the Federal Reserve, by raising their interest-rate target during a time when many questioned the move, perhaps wants to test this theory.

At any rate (pun intended), Americans are right to question whether the Fed's actions have had the intended results, whether they've benefitted anyone besides banks, and whether the Fed is experimenting with the economy at a time where everything feels pretty fragile. Let's hope the presidential field understands these concepts and lets us know where they stand sometime soon.

Gatto is the longest serving member of the California State Assembly Committee on Banking and Finance, overseeing the world’s 8th largest economy.  He represents California’s 43rd Assembly District, which includes Los Angeles, Glendale and Burbank. www.asm.ca.gov/gatto