“We are – I’ll be blunt – audited out the wazoo. Every Federal Reserve Bank has a private auditor. We have our auditor of the system. We have our own inspector general. We are audited. What he’s talking about is politicizing monetary policy.” Richard Fisher, President, Federal Reserve Bank of Dallas, Dallas Morning News, February 9, 2015.
What would you think if you were to open your morning newspaper to find the following headline?
“Congress Closes Down Fed, Takes Over Monetary Policy”
If you’re like us, you’d panic. In short order, you’d think that long-term inflation expectations would rise, pushing bond yields higher. You’d anticipate an increase in the volatility of growth, employment and inflation. That more volatile environment would drive up the risk premium required on new investments, hindering long-term economic growth. Finally, you'd be very worried about how these Congressional policymakers would manage the next financial crisis.
This is not a pretty picture. Why would anyone want it to become a reality? Well, these are surely not the intended goals, but they are the likely outcomes should lawmakers ever replace the Federal Reserve Board with what we would call a Congressional Reserve Board.
While the Federal Reserve Transparency Act of 2015 – aka, the “Audit the Fed” Act – doesn’t shut down the Federal Reserve, it would go a long way to putting Congress directly in charge of monetary policy and to weakening the Fed’s effectiveness as a lender of last resort.
To explain our concerns, we will start by describing why it has become almost universally accepted practice to make the institution setting monetary (and regulatory) policy independent of political interference. That is, why most advanced and emerging market economies have opted to make their central banks “independent.” We will also explain why the “Transparency Act” is really about controlling monetary policy, not about making the Fed accountable (the short answer: it already is). And, finally, we will explain the bill’s impact on the Fed’s lender of last resort powers.
But, first, let’s take a step back and ask what accounts for U.S. political opposition to central bank independence if its economic logic is so strong? In our view, recent efforts to reign in the Fed are just a recurrence of long-standing (and healthy) American distrust of the concentration of financial and political power in the hands of a few (especially an unelected few). This same suspicion brought an end to the first two U.S. central banks in 1811 and 1836, and delayed until 1913 the creation of the Federal Reserve, despite a series of financial panics after the Civil War at a rate of more than one a decade.
In the current episode, the Fed’s aggressive use of emergency powers during the financial crisis to rescue the financial system – especially its behemoths – revived popular antipathy at both ends of the U.S. political spectrum. On top of the 2008 bailouts, the Fed’s use of its balance sheet to counter the crisis and promote economic recovery also led some to argue that the central bank was risking hyperinflation, a view that even at the time seemed seriously mistaken.
So, what does central bank independence mean and what are its benefits? Let’s start by clarifying what it is not: independent central banks do not set their own objectives. That authority is reserved for elected officials and governments. In addition, independent central banks are not free of oversight or accountability. Quite the opposite: Elected officials and the public properly expect central banks to explain how they will reach their legally mandated goals and, in the event that they fail, to explain why.
Importantly, central banks today value the public attention associated with transparency and accountability because it improves their odds of success. Many central bankers of the past would have endorsed the supposed motto of the Bank of England’s pre-World War II leader, Montagu Norman: “Never explain, never excuse.” Modern central bankers are convinced of the opposite. In the words of former Fed Chairman Ben Bernanke, “If effective communication can help financial markets develop more accurate expectations of the likely course of the [federal] funds rate, policy will be more effective.”
Central bank independence is really about tools. An independent central bank is authorized to use a specific set of policy tools (usually related to its balance sheet and lending authority) to achieve its legally mandated objectives free of intrusive political review in the short term. In the United States, neither Congress nor the President can reverse a monetary policy decision of the Federal Open Market Committee (at least not without changing the Federal Reserve Act).
To make the Fed “tool independent” in practice, existing law shields current monetary policy discussions and decisions from direct congressional audit. Direct and immediate review of, say, the proceedings of FOMC meetings would turn Congress into the true backseat driver.
So, what are the benefits of independence that made Congress (and the legislatures of many other nations) opt to delegate tool independence to a group of unelected officials? The answer – from a large body of research – is that an independent central bank delivers low inflation with a smaller sacrifice of output and employment (see chart below). We see this as the closest thing we know to a free lunch (and, while this view is not free of dissent, it is widely shared among economists).
Central Bank Independence and Inflation over the Long Run
Why does independence work? Probably because the policy horizon of central bankers (who, in the United States, are appointed for terms of up to 14 years) is longer than that of elected officials, so that they are less tempted to trade a rise in long-run inflation for temporary gains in output and employment. In contrast, politicians are always running for election and have strong incentives to make today’s (rather than tomorrow’s) voters as happy as possible. (In economic jargon, independence helps overcome the time consistency problem by constraining discretionary monetary policy.)
Turning to financial stability and crisis management, the authority of central banks to act as lender of last resort is also more effective when it is delegated to an independent agency. In the midst of a financial crisis, publicizing information on who is borrowing from the central bank is incendiary, triggering bank runs. Should banks become hesitant to borrow from the central bank, their efforts to hoard liquidity would hurt the economy.
It is a challenge to make central bank independence square with representative democracy. But the solution is for elected officials to hold independent central banks accountable. And they do.
The Federal Reserve Transparency Act of 2015 should be viewed primarily as an attack on the Fed’s independence. Americans should and do like transparency. So do we. That makes the Act’s name sound attractive (more so than the “Audit the Fed” Act, anyway). But the fact is that we already enjoy unprecedented disclosure by the Fed. There are press conferences; publication of FOMC statements, minutes, transcripts, FOMC members’ projections of economic activity, inflation and policy rates, and regional activity assessments; public speeches; frequent congressional testimony; weekly balance sheet publication; and regular audits of Fed finances by private and government organizations.
By auditing monetary policy, the Transparency Act would allow Congress direct oversight of things like interest rate and balance sheet decisions, and could severely damage lending as a tool of crisis mitigation by risking the premature release of details about borrowers. Point of fact: In compliance with the disclosure requirements of the Dodd-Frank Act, the Fed already releases transactions data from all discount window loans and open market operations with a lag of about two years. [You can find these data, covering thousands of transactions, in spreadsheets here.] That two-year delay allows for accountability, while also preserving the lender-of-last-resort tools that again could be needed to contain a financial crisis.
Let’s be clear. We’re all in favor of vigorous Congressional debate and periodic review of the Fed’s mandate. It is up to Congress to determine the proper balance between the goals of price stability and stable growth.
We’re also in favor of having Congress carefully define the tools – as it does in the Federal Reserve Act – that the central bank can legitimately use. For example, the law does not authorize the purchase of the liabilities of corporations – debt or equity – or even the general obligation debt of municipalities. So, you will not find these instruments on the Fed’s balance sheet. If Congress doesn’t want to the Fed to purchase federal-government backed mortgage debt (they currently hold over $1.7 trillion worth), they can change the law (we wouldn’t advise it, but that’s another matter).
Our bottom line is simple: a Congressional Reserve Board is a really bad idea, but that’s what an audit of monetary policy would create. Instead, Congress should maintain and advance the current framework of delegating circumscribed authority to a transparent, accountable and independent Federal Reserve that can contribute to prosperity by keeping inflation low, employment high, and the financial system robust.