Open Letter to Senator Rand Paul

We read with interest your August 21 Bloomberg View that calls for “a thoughtful congressional discussion of the pros and cons of a more thorough audit” of the Federal Reserve. While we share your desire for effective congressional oversight of the Federal Reserve, we strongly disagree on the best way to do it.

In our democracy, Congress must hold the Fed accountable for achieving its economic and financial stability mandate. Congress has wisely delegated circumscribed authority over monetary policy and the lender of last resort function to the Federal Reserve. Doing so is consistent with long experience showing that central bank operational independence helps secure price stability and that the lender of last resort bank can prevent and mitigate financial crises. But for this to be sustainable, Congress must retain sufficient oversight to guarantee that the Fed uses it powers in a manner consistent with its legal mandate. To take but one of many examples, no one wants the central bank to bail out insolvent banks.

On this much, we agree.

However, you go on to suggest that the current level of Fed transparency is insufficient to achieve the required level of accountability. While we would have agreed with this view in 1990, we strongly disagree today. It would be difficult to overstate the Fed’s shift toward transparency over the past two decades. Before 1994, the Federal Open Market Committee (FOMC) routinely altered monetary policy without informing the public! Today, we have a clearly stated policy framework, FOMC meeting statements, press conferences, minutes, quarterly publication of participants’ economic and interest rate projections, officials’ speeches, testimony, staff reports, and the list goes on. The information flow is so voluminous that we doubt there is any single person who can digest it all in a timely way.

Even the most sensitive information regarding specific Fed bank counterparties is now fully disclosed. For example, anyone who wishes to see the details of each Fed loan (including size, interest rate, maturity, collateral, etc.) can find it here with a lag of about two years.

Despite these extraordinary advances, the Fed appropriately considers its communication policies to be a work in progress. Officials are continuously seeking new and better ways to help Congress and the public hold it accountable. To the extent feasible, the goal is for everyone to understand the factors that drive monetary policy, so that we can interpret economic and financial developments much as the FOMC will.

In your Bloomberg View you ask for more, suggesting that increased transparency is always desirable. You then suggest that the Government Accountability Office (GAO) could comment on the Fed’s impact on our fiscal well-being. This seems benign, but it also would be of limited value. The Fed already provides full details on its asset holdings (see here) allowing anyone who wishes to go to the trouble to both compute the market value of its assets and to judge the solvency risks it faces. So far, the most thoughtful analyses see only a modest threat (see Fed economists’ published studies here and here).

We note, however that if the Fed’s balance sheet is thought of as part of the government’s balance sheet, as you reasonably suggest, then there would be little worry if mark-to-market losses resulted temporarily in a position of negative net worth for the central bank – provided that this does not become an excuse for encroaching on the Fed’s policy independence. As we have argued, even a sizable capital shortfall would be very small compared the value of future seigniorage associated with a monetary policy committed to price stability.

As a somewhat separate matter, you express concern about the Fed’s payment of interest on banks’ account balances. These payments reward banks for holding reserves, which are the safest and most liquid assets in the financial system. This enhances financial stability. But because they hold the largest deposits at the Fed, foreign banks and large U.S. banks are the largest recipients of these payments, which are set to grow as the Fed tightens policy. That makes these payments an easy target for populist attacks.

Yet, in the Financial Services Regulatory Relief Act of 2006, Congress specially authorized payment of interest on reserves. This is something the Fed began doing at the height of the crisis as a part of their effort to reestablish stability of the financial system. Looking forward, this tool is likely to be the key instrument that the Fed will use to tighten monetary policy as it seeks to safeguard price stability and extend the life of the current expansion. Rather than creating a conflict between financial stability and other central bank policy goals, the authority to pay interest on reserves is a key element in helping to secure them. Indeed, before October 2008, the Fed was the only major central bank that lacked this policy tool.

Ultimately, our disagreements with what you write in Bloomberg are minor compared with those we have with the details of your proposed legislation, the Federal Reserve Transparency Act of 2015. Our view is that the practical implications of your bill would be to render the Fed ineffective both as a monetary policymaker and as a guardian of financial stability. Consequently, we naturally wonder if the purpose is to “End the Fed” rather than to “Audit the Fed.”

The first major change that your bill would introduce is to allow the GAO to audit monetary policy decisions per se. This is tantamount to eliminating central bank independence. Instead, effective control over monetary policy would revert to congressional oversight committees. A GAO audit of this kind could be used to dissect every comment by every participant at every FOMC meeting as they seek to form a consensus about the outlook for growth and inflation, the path of interest rates, the mix and scale of the Fed’s balance sheet, and the way to communicate their decisions. With the give-and-take needed for thoughtful debate and inquiry already constrained by existing disclosure policies (see, for example, here), the damage to information-sharing and forthright discussion would weaken Fed credibility, while direct interference by congressional committees would risk undermining it completely.

The second major change you propose is to permit instant audits of Fed financial transactions. Nearly everything except discount window lending operations is already disclosed as it occurs, so anyone who has the time and interest can audit that. But in the case of bank lending, your proposal could do as much harm as the Vitter-Warren bill – which, if enacted, would require the immediate release of the borrower’s identity (see here).

Why would immediate release of information about the identity of specific discount window borrowers be potentially so damaging? As we mentioned earlier, under the enhanced disclosure framework established by the Dodd-Frank Act, detailed information on discount borrowing is now published on the Fed’s website with a lag of about two years. This level of disclosure already may make banks squeamish, because borrowing from the Fed is commonly viewed as a sign of fragility. However, if banks come to fear that disclosure will occur during an episode of financial stress, the heightened stigma of borrowing could easily turn what started as mere stress into full-blown crisis.

Preventing and mitigating such disruptions is precisely the reason that Congress created the Fed in 1914. We know from the history of the late 19th and early 20th century that if we were to strip the Fed of its ability to provide liquidity to solvent banks in times of stress, the result would be frequent bank panics and deep recessions.

Our bottom line: we support any improvements to congressional oversight that will help make the Fed more effective in meeting its legal mandate of high employment and price stability. We welcome a public discussion of the best way to do this. We also welcome a periodic review of the Fed’s mandate to make sure that it continues to reflect the popular will. Yet, the Fed already has evolved into one of the most valuable and effective institutions that Congress ever created. Fed independence is necessary to sustain this accomplishment. While public discussion and review are essential if we are to continue to delegate authority as powerful as that of a central bank to an independent institution, we see the call to “audit” contained in your bill as more likely to undermine than to advance this cause.