by Charles I. Plosser
In the aftermath of the global financial crisis and accompanying recession, some people have asked whether the governance and structure of the Federal Reserve System should be overhauled. In this essay, I explain why I believe the system that Congress established nearly 100 years ago still serves the public interest and why some proposed changes to its structure would pose serious risks to the health of our economy.1
Over the past two years, the Fed has taken extraordinary and unprecedented actions to respond to the financial crisis. Now, as the economy begins to recover, the debate has turned to ways to prevent the next crisis, and it is entirely appropriate that we address the critical issues of moral hazard and firms deemed too big to fail. In doing so, though, we must guard against implementing regulatory reforms that have unintended consequences. To avoid harming the economy, we must refrain from undermining the Fed's ability to achieve its congressional mandates of price stability with maximum employment and sustainable economic growth, as well as the Fed's ability to foster financial stability.
In particular, proposals that reshuffle the regulatory landscape and attempt to make the Federal Reserve, and thus monetary policy, more political miss the mark of meaningful reform. (See "A Way Toward Real Reform".) In fact, they would weaken the Fed's independence and the prospects that the Fed can carry out its mandates to achieve price stability and promote sustainable economic growth. Let me explain why.
First, it is important to understand the structure and governance of the Federal Reserve System, which has enhanced its effectiveness for nearly a century. The structure is often misunderstood. Yet, I believe history helps us understand why we have a regional and independent central bank.
Just blocks away from the Federal Reserve Bank of Philadelphia stand the historic buildings that once housed the First and Second Banks of the United States. Both failed because they became embroiled in politics and lacked the balance and independence needed to serve our vast and diverse country. (See "The First and Second Banks of the United States: The Historical Basis for a Decentralized Fed.") When President Woodrow Wilson signed the Federal Reserve Act into law in 1913, it included an ingenious compromise — a decentralized central banking system.
The Fed's unique structure helped overcome political and public opposition that stemmed from fears that the central bank would be dominated either by political interests in Washington or by financial interests in New York. Americans have long been suspicious of the concentration of authority. A decentralized central bank allowed Congress to spread authority for central bank policy throughout the nation.
Congress established the Federal Reserve System by chartering 12 regional Reserve Banks, overseen by a Board of Governors in Washington, to provide checks and balances — between centralization and decentralization, between the public and private sectors, and between Wall Street and Main Street — all to ensure that policy decisions are balanced and independent. (See "Federal Reserve System Structure and Governance: A Balance of Power.")
The regional structure of the Federal Reserve System also helps the Federal Open Market Committee, or FOMC, to set more effective monetary policy. Congress gave votes on the FOMC to the seven Governors in Washington, along with five of the 12 presidents of the regional Reserve Banks. As the president of the Philadelphia Fed, I receive a lot of information about business and financial conditions in the Third District, which includes Delaware, the southern half of New Jersey, and the eastern two-thirds of Pennsylvania. I also reach out more broadly to contacts in the national and international business communities. In addition, here in Philadelphia, our Research Department collects survey data from around the District and the nation and constructs indexes of economic activity. The results are published in a number of publications. The most recognized and frequently cited are our Business Outlook Survey, our Survey of Professional Forecasters, and our coincident indexes for the 50 states. (See "Providing Reliable Information on the Economy.") I use all of this information, along with incoming data on the national economy, when I prepare for meetings of the FOMC, held typically every six to eight weeks in Washington.
At those FOMC meetings, I share what I have gathered as I express my views about the economy, just as I hear the perspectives of other Fed presidents and Governors. It is the aggregation of those diverse views on the state of the economy and proposed policy actions that shape the FOMC's monetary policy decisions, so that our nation's monetary policy reflects the most up-todate and comprehensive picture of the economy. The information from the Reserve Bank Districts, in its detail and timeliness, is often invaluable in understanding how our economy is evolving.2
In formulating policies, it is valuable to hear perspectives on the economy and policy from throughout the country — not just from Wall Street or Washington, but also from Philadelphia and the other Districts of our uniquely decentralized central bank. The diverse and independent voices that are represented in the making of monetary policy result in a stronger and more effective institution and better policies. As the famous American journalist Walter Lippmann once said: "Where all men think alike, no one thinks very much."
By bringing an independent view and a regional Main Street perspective to Washington, the 12 Reserve Bank presidents help maintain a balanced and richer decision-making process, improving policy and economic outcomes on behalf of the entire country.
Congress wanted a central bank that was both decentralized and independent within government in order to shelter it from short-term political influences. To help reinforce the central bank's independence, Congress established the Fed to be self-funding, meaning that the Fed receives no government appropriations from Congress. In fact, the System turns over any excess earnings on its portfolio of securities and loans above the cost of its operations to the U.S. Treasury. In 2009, that amounted to about $46 billion returned to the Treasury.
To further preserve the Fed's political independence, Federal Reserve Bank employees, officers, and directors are generally restricted from engaging in political activities.
However, independence does not mean that the central bank is unaccountable for its policies, nor does it mean that the Federal Reserve sets its own goals. Congress sets the Fed's monetary policy goals. The Federal Reserve Act states that the Fed should conduct monetary policy to "promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." Since moderate long-term interest rates generally result when prices are stable and the economy is operating at full employment, it is often said that Congress has given the Fed a dual mandate.
What central bank independence means is that Congress has left the decisions of how best to achieve this mandate to Fed policymakers, free from short-term political interference. As former Fed Vice Chairman Alan Blinder has explained, Congress knew the temptation to interfere with monetary policy was great and that such interference would be detrimental to society. So, Congress tied its own hands, just as Ulysses had himself tied to the mast of his ship as it sailed past the beautiful and tempting, but deadly, Sirens.3
Many people may wonder why in a democratic society we leave monetary policy decisions in the hands of nonelected policymakers who can act with independence. There are two very good reasons for this structural independence for the central bank.
The first and most important reason is to separate the authority of those in government responsible for making the decisions to spend and tax from those responsible for printing the money. This lessens the temptation for the fiscal authority to use the printing press to fund its public spending, which would substitute a hidden tax of future inflation for taxes or spending cuts.
This can be especially important when governments face huge deficits and may be tempted to use the monetary printing press to improperly fund fiscal needs. The fiscal authorities should not think of the central bank as a source of funds or a piggy bank they can use simply to avoid the difficult choices of cutting spending or raising taxes.
History is replete with examples in which central banks became agents for a nation's fiscal policy or a means for a political party to remain in power. Just in the 20th century, think of the hyperinflation experiences in Germany and Hungary; think of Italy before the euro; think of the numerous financial crises in Latin America or the current economic chaos in Argentina and Zimbabwe, to name just a few. The consequences of using the printing press as a substitute for spending restraint are dire — higher inflation, currency crises, and economic instability.
Here in the U.S. there have also been periods where fiscal demands and monetary policy became too intertwined. For example, in the late 1960s and early 1970s, the Fed came under pressure from the Treasury and the administration to support the funding of the Great Society programs and the Vietnam War. As a result, the Fed became reluctant to raise interest rates to restrain inflationary pressures. This failure of the Fed to exert its independence sowed the seeds of the Great Inflation in the 1970s. As unemployment rose in response to the disruptions caused by the oil shocks in that decade, the Fed remained reluctant to raise rates sufficiently in the face of rising inflation. Thus, the failure to keep monetary policy sufficiently independent led the Fed to forsake its mandate for price stability, which resulted in more than a decade of economic instability.
More than ever before, we live today in a world of highly mobile capital and financial markets that are constantly assessing the credibility of governments and their central banks to maintain price and economic stability. In such a world, the mere threat that monetary policy might become politicized can damage the nation's credibility. It can raise fears of inflation that send interest rates higher and currencies falling.
The second reason central bank independence is important is that monetary policy affects the economy with sometimes long and variable lags, but elected politicians, and even the public, often have shorter time horizons. Monetary policy actions taken today will not have their full effect on the economy for at least several quarters and perhaps as long as several years. That is why monetary policy choices must focus on the intermediate to long term and anticipate what the economy might look like over the next one to three years.
Moreover, there can be a conflict between what monetary policy may be able to achieve over the short term versus its impact over the long term. For example, sustained monetary policy easing, achieved by lowering interest rates, is often perceived to have beneficial effects on employment and output in the near term. Yet such effects are temporary at best and are highly unpredictable. Moreover, in the long term such a policy is likely to result in higher rates of inflation and higher nominal interest rates. On the other hand, a tightening of policy to restrain inflation will first show up in declines in employment and output; only later will those effects be reversed and inflation fall. This pattern engenders an inflationary bias in policy if policymakers become too short-term oriented. Delegating the decision-making to an independent central bank that can focus on long-term policy goals is a way of limiting the temptation for short-term gains at the expense of the future.
Independence will be even more important for the Fed going forward. During the recent crisis, the Fed took extraordinary measures. At some point, however, the Fed must unwind this support, increase short-term interest rates, and drain some of the money it has pumped into the economy during the recession. The Fed must have the independence to take these actions without short-term political interference if it is to achieve Congress's dual mandate.
Instead of seeking to preserve or enhance the central bank's independence, however, some reform proposals would politicize the governance of the 12 Reserve Banks by making the New York Fed president, or even other Reserve Bank presidents, political appointees. Other proposals would change the roles and responsibilities of the Fed.
Such changes would weaken the regional and decentralized structure of the Federal Reserve System and lead to a more centralized and political institution, which would yield less effective policymaking. Were regional Reserve Bank presidents to become political appointees, they would be more attuned to the political process in Washington that selected them, rather than having a public interest in the broad economic health of the nation and the Reserve Districts in which they reside.
Any shift in power in Washington and New York at the expense of the other Reserve Banks would undermine the delicate balance of our uniquely decentralized central bank and lead to a central bank that is more interested in politics and Wall Street than in the economic health of Main Street. Such a shift in the focus of the central bank would be a loss for the country and our economic well-being.
Being independent, though, does not mean the Fed is unaccountable. The Fed is ultimately accountable to Congress and the American people. Having been granted the independence required to implement effective monetary policy on behalf of the country, the Fed has an obligation to explain its policy decisions to the public. Communicating the Fed's actions helps establish the central bank's credibility and reaffirm its commitment to achieving its mission, which in turn generates better policymaking. Transparency allows Congress and the public to better understand the Fed's policy actions and to hold the Fed accountable for the outcomes.
Recognizing that the Federal Reserve is ultimately accountable to the American people, the Fed has steadily improved transparency about its actions in recent years. For example, the Federal Open Market Committee issues a statement after each meeting, detailed minutes three weeks later, and quarterly economic projections of participants. Verbatim transcripts of FOMC meetings are available after five years.4 The Fed Chairman testifies to Congress on monetary policy at least twice each year and frequently appears before House and Senate committees to answer questions. In addition, Reserve Banks help increase transparency by communicating economic and monetary policy objectives through educational outreach, speeches by Bank officials, and discussions with the boards of directors and local constituents.
Each year the Fed provides Congress and the public with detailed financial statements audited by an outside independent public accounting firm. The Fed also publishes a balance sheet on a weekly basis and has recently added monthly and quarterly data to increase its level of transparency.
I am keenly aware of the importance of transparency, so I fully support the Fed's efforts to improve and enhance its disclosures surrounding the unusual policy programs we have implemented in response to the crisis. Failure to do so can harm our credibility and reputation, undermining the public trust and the Fed's ability to achieve its objectives.
The Fed's budget and operations are subject to considerable oversight. Internal audit departments, which report directly to the Banks' boards of directors, regularly audit the Reserve Banks' operations. Staff at the Board of Governors also oversees the Reserve Banks' operations throughout the System. The Government Accountability Office (GAO) also conducts frequent audits of many of the Fed's functions, including the financial services provided to the U.S. Treasury and other government agencies, and the Fed's supervisory and regulatory functions.5
What Congress correctly decided in 1978, though, is to exempt monetary policy decisions, including open market and discount window operations, from GAO review to avoid politicizing monetary policy and jeopardizing the independence of the central bank. Recent proposals to remove this exemption for monetary policy would allow any legislator to demand that the GAO audit the Fed's monetary policy decisions. To be clear, this "audit" does not refer to the usual accounting sense of the term, since the Fed's financial statements and controls are already subject to extensive outside audits by the GAO and a public accounting firm. Rather, this proposal is an attempt to reduce the independence of the central bank and influence policy through the threat of a political action. The GAO could be ordered to investigate a monetary policy decision whenever any member of Congress opposes a decision to change interest rates. These "policy audits" would undermine the Fed's credibility as well as its ability to conduct monetary policy in the best interests of the American public.
Such policy audits would also reverse a trend of the past three decades in which many countries have increased the degree of independence of central bank monetary policymaking from short-term political influences. Empirical research over the past 30 years has shown that countries with independent central banks have lower rates of inflation, on average, and generally better economic performance.6
Rather than seek ways to politicize the Fed, we should seek ways to ensure its independence from short-term political pressures while reducing the temptation to use the central bank as an inappropriate tool for conducting fiscal policy.
Several actions could be taken to support these goals. I would like to emphasize two that I believe are particularly important.
First, the Federal Reserve should conduct monetary policy using a portfolio that contains only Treasury securities, preferably concentrated in bills and short-term coupon bonds. This would contribute to preserving the Fed's independence by limiting activities that could be perceived as crossing the line from monetary policy into the realm of fiscal policy. The Federal Reserve's purchases of mortgagebacked securities were a direct intervention into housing finance and thus can be viewed as a form of fiscal policy. In order to return the composition of the Fed's portfolio to all-Treasuries, I would support the Fed's beginning to sell the agency mortgage-backed securities from its portfolio as the economic recovery gains strength and monetary policy begins to normalize. Returning to an all-Treasuries portfolio would promote a clearer distinction between monetary policy and fiscal policy and help uphold the Fed's independence.
The second suggestion is to eliminate or curtail the Fed's 13(3) lending authority.7 This section of the Federal Reserve Act allows the Fed to lend to corporations, individuals, and partnerships under "unusual and exigent circumstances." I believe the fiscal authorities should do emergency lending and that the Fed be involved only upon the written request of the Treasury. Any non-Treasury securities or collateral acquired by the Fed under such lending should be promptly swapped for Treasury securities to make it explicitly clear that the responsibility for fiscal policy lies with the Treasury and Congress, not with the Federal Reserve. To codify this arrangement, I have advocated for a new Fed-Treasury Accord, similar to the 1951 accord that restored Fed independence after World War II.8 This new accord would eliminate the ability of the Fed to engage in bailouts of individual firms or sectors and place such accountability where it rightly belongs — with the fiscal authorities.
The most severe financial crisis since the Great Depression has prompted the call for financial reforms. History tells us that crises invariably lead to reforms, and as we struggle to find the right reforms to respond to this crisis, we should avoid "quick fixes" that may have unintended consequences that impair the Federal Reserve's ability to achieve the monetary policy goals set by Congress.
Above all, we must preserve the independence and regional nature of our Federal Reserve System against proposals that would threaten to politicize or centralize power. Failure to do so could impede the Fed's ability to meet its objectives for sound monetary policy to ensure price stability and maximum sustainable economic growth. The Fed's regional governance, independence, and current responsibilities are all important for achieving these objectives.
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