Saving the Fed from Itself
Steve Stein
F
eder a l R e serv e ch a ir Janet Yellen’s three immediate predecessors — Ben Bernanke, Alan Greenspan, and Paul Volcker — were
each originally appointed by a president from one party and later
re-appointed by a president from the other. The Fed’s relative insulation from partisan politics has been a source of strength for previous
Fed chairmen, including Bernanke, even when their policies became
controversial. Yellen, however, received only 11 Republican votes for confirmation, so if the White House changes hands in 2016, she is a long
shot to continue that tradition. This diminished bipartisan support for
the head of the central bank isn’t good news.
Yellen’s support has been narrower and less bipartisan not simply
because of her own background in Democratic Party circles or even because of increased polarization in politics. It has at least as much to do
with the changing character of the Federal Reserve’s work and role in our
economic and political systems. Since the 2008 financial crisis, the aims
of the Fed and the tools it employs have undergone a significant transformation, the implications of which — for the central bank’s independence
and for the system in which it plays such an important part — are only
beginning to be understood.
In the last seven years, the Federal Reserve has both pursued an extremely aggressive policy of monetary stimulus to support the economy
and vastly expanded its regulatory power over the financial sector.
Gradually, under both Bernanke and Yellen, and in what began as a
largely understandable response to the peculiar demands of the last few
years, the Fed has become less of a traditional central bank and more of
a highly unorthodox driver of economic activity and an increasingly active regulator and overseer. These new roles, and especially the second,
St e v e St e i n is an investment manager and financial writer in Marin County, California.
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N at iona l Affa ir s · W i n t e r 2015
could pose grave challenges to the Fed’s independence in the years to
come. And Yellen has not only taken lead of the Fed in the midst of these
changes but has also cheered them on and sought to reinforce them.
The independence of the Federal Reserve may well be more threatened in the coming years than at any time in the 100-year history of
America’s central bank. That independence could prove impossible to
protect as long as the Fed continues to exchange its role as a defender of
monetary stability for a new role as the ultimate overseer of the financial
system. That new role is an inherently political one, and the Fed cannot
expect to be permitted to perform it without interference from the democratically elected institutions of our political system. Keeping the Fed
independent of political domination and respected across the partisan
spectrum may require rethinking the turn it has taken in recent years.
E x t r aor di na ry Me a sur e s
When we think of the challenges facing the Federal Reserve, we generally still think in terms of interest rates, economic growth, and inflation.
And there is no question that this traditional set of concerns has played
an important role in shaping the increasingly complicated situation in
which the central bank has found itself.
When the Fed seeks to lower interest rates to spur growth, its preferred method is to inject money into the financial system by buying
government securities from financial institutions. The “federal reserve
notes” used for payment are instruments the Fed can print with essentially no external constraint. Immense power has accrued to successive
Fed chairmen this way over the years. Occasionally, the money printing
seems excessive to some observers and raises alarms, and this has certainly happened some in recent years. But easy money generally draws
more friends than enemies, and the prospect of the public response to
a reversal of the Fed’s near-zero interest rates is more daunting than the
criticism the central bank now receives for continuing that policy. At the
Fed’s recent annual conference in Jackson Hole, Wyoming, demonstrators wearing green shirts emblazoned with the slogan “What Recovery?”
preemptively protested against hints of any movement toward tighter
money, offering just a tiny sample of the response that would accompany such a move.
When the Fed does face the need to tighten, as it must sooner or
later, it will be starting from a rate of practically zero and proceeding
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to one that likely will still remain low by historical standards. Even so,
a series of only four one-quarter-of-a-percent increases, while mild in
absolute terms, could be experienced traumatically when measured on
a relative basis: An increase from .25% to 1.25% is a 400% rise. Stating the
matter that way dramatizes the enormous leverage that has been built
into the current system. Sophisticated financiers have been borrowing
at ultra-low short-term rates, then making loans at somewhat higher
rates with longer maturities, and profiting nicely on the spread. When
the Fed does start raising rates, the market will have trouble reacting
in any way other than a sharp turn away from such practices, and the
central bank will have its hands full managing grim expectations and
keeping things calm.
This relatively familiar pattern is not the only challenge the Fed will
need to confront when the time comes to end its emergency measures,
because those measures have been unusual not only in size but also in
composition. Under the label “quantitative easing,” Bernanke responded
to the 2008 crisis by greatly enlarging the practice of buying long-term
securities, in addition to the more common short-term securities. This
has had the effect of flattening the so-called “yield curve.”
Traditionally, one way the market can signal that Fed policy might
have become too accommodative is by increasing the spread between
long-term and short-term rates — showing that people expect trouble
in the near-term and are instead betting on the economy’s longer-term
performance for safety. But if the Fed, through the aggressive purchase
of long-term bonds, distorts both ends of the yield curve, this signal no
longer operates as it should. When the yield on a two-year bond is barely
distinguishable from the yield on a 30-year bond, the market lacks a crucial source of information about public expectations that might inform
the central bank’s decisions.
And Bernanke didn’t stop there. He liberally employed a formerly
little-used rule that allowed the Fed to purchase assets other than
Treasury notes in “unusual and exigent circumstances.” So, besides buying long-term Treasury obligations, the Fed also increased its purchases
of mortgage-backed securities, the very assets at the core of the financial crisis. Since financial institutions were either unable or unwilling
to lend most of the money they received in exchange for these assets,
those funds have remained on deposit at the Fed. In yet another unprecedented move, the Fed now pays the banks interest on that money, and
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at a rate generally higher than banks pay their own depositors. For fiscal
2014, those payments amounted to over $5 billion.
When the Fed eventually does raise short-term rates, it will also have
to raise the interest it pays on those excess reserves. Otherwise, banks
will withdraw those funds too quickly and add to the money supply,
counteracting the Fed’s policy objective. Indeed, increasing its interest
rate on excess reserves may well become a primary instrument in the
Fed’s monetary toolkit.
All of this means the Federal Reserve faces a very precarious balancing act as it rolls back the various facets of its response to the crisis,
recession, and weak recovery of the last few years. Every step it takes will
confront great political pressure that will endanger the central bank’s independence. Former Fed chairman Alan Greenspan, in remarks before
the Council on Foreign Relations this fall, emphasized the difficulties
he foresees when markets demand higher rates from the Fed to keep
reserve balances stable. Choosing his language carefully, Greenspan
turned aside his interviewer’s assertion that he was predicting a “crisis”
when the Fed exits its accommodative monetary policy. He preferred,
instead, the word “turmoil” — which is hardly reassuring.
Greenspan avoided commenting directly on Bernanke’s unconventional monetary policy, or on Yellen’s follow-up actions. But he left little
doubt that he believes that, as the Fed’s reach has expanded, its vulnerability has grown. And that reach has expanded far past its traditional
role as the manager of monetary policy.
A Cen t r a l R egul ator ?
Even in 2009, in the wake of the worst of the crisis when discussions
about reforms of the federal government’s mechanisms for regulating
the financial system were just beginning, Congress had already become
concerned about the Federal Reserve’s increasing power over the system.
As the package of reforms that would ultimately become the 2010
Dodd-Frank Wall Street Reform and Consumer Protection Act took shape,
such concerns were frequently voiced. To address those concerns, early
drafts of the bill sought to rein in the Fed by putting regulatory power in
the hands of other federal bodies, including some newly created ones. But
as legislators ran into a series of challenges regarding bureaucratic design
and (especially) making room in the budget for new agencies, they ironically ended up opting to give the Fed more of a role, rather than less.
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As originally envisioned, for instance, the bill would have created
a Consumer Financial Protection Bureau separate from the Fed to
oversee the relationship between the banking system and its clients.
But the proposed agency’s lavish budget ran into trouble in Congress,
and the compromise solution was a CFPB under Fed auspices and managed with Fed resources. Other agencies, including the Securities and
Exchange Commission, were granted additional rule-making authority under Dodd-Frank, but also didn’t receive sufficient funding to
carry out their new mandates. So they, too, were made to share their
rule-making tasks with the Fed, which is able to fund itself outside of
the normal federal budget.
Another original feature of the Dodd-Frank bill proposed to give the
Government Accountability Office (an agency of Congress) extensive
power to audit the Fed’s monetary-policy decisions. But citing the “chilling effect” of excessive supervision as a threat to the Fed’s independence,
Bernanke persuaded legislators to squelch that provision.
In fact, the final bill not only declined to subject the Fed to new congressional supervision, it ended up conferring upon the Fed some very
significant additional powers, above and beyond its peculiar power of
the purse over other agencies. First, there is the responsibility (shared
with other institutions) to administer the “Volcker Rule,” which is supposed to limit banks’ ability to trade securities for their own accounts.
Such a rule is necessarily ambiguous; as banks trade for their customers,
they may still need to own securities in their own accounts long enough
to ensure an orderly market. The Fed has wide discretion to resolve the
ambiguities that can arise from such operations.
One of the most prominent of Dodd-Frank’s provisions is the establishment of the Financial Stability Oversight Council. Intended to establish
tighter rules for a variety of “systemically important financial institutions”
whose failure could ripple through the system, the FSOC is chaired by the
Secretary of the Treasury and includes the heads of all the major financial
regulatory agencies. On its face, the FSOC doesn’t particularly enhance
the Fed’s power, but rather requires the Fed to share the power with others. But in practice, the FSOC will almost certainly enlarge the Fed’s writ.
As various non-bank financial institutions are identified as “too big to
fail,” they will almost certainly come under closer Fed supervision.
The result of all of these new provisions is a Federal Reserve with immense new regulatory authority — at the same time that it has gained
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powerful new tools for managing the money supply and cushioning the
business cycle. And while all of this has clearly happened as a result of the
2008 crisis, the Fed itself has hardly been reticent to assume these new
powers. It has sought most of them, and generally welcomed the rest.
A “M acropruden t i a l” Fed
In Washington, as elsewhere, power abhors a vacuum, and even before
Janet Yellen had officially acceded to her new office, many were urging her
to make sure the Fed fulfilled its destiny amid what seemed like the dawning of a new era for American capitalism. Robert Kuttner, editor of the
progressive magazine the American Prospect, greeted Yellen’s nomination in
2013 with an essay titled “The Fed Transformed,” happily noting that Yellen
was not just another “Wall Street-friendly senior Obama official” but would
be the first labor economist to run the Federal Reserve. Kuttner continued:
Never before in the Fed’s hundred-year history has its independence resulted in a central bank more committed to strict
financial regulation and expansive monetary policy than the executive branch. Ironically, progressives who have long railed against
the Fed’s insulation from politics are now cherishing it.
Nor has Yellen, despite her modest demeanor, shied away from a strongly
activist role. She has left little doubt of her predisposition to maintain
a monetary policy as accommodative as those of her last two predecessors. Nor is she overly concerned that such a policy might inflate asset
values to the point of risking financial instability. For one thing, she
believes there are now regulatory tools at her disposal that her predecessors did not have or were not willing to use. Greenspan, for his part,
believed that dangerously inflated asset values (or “bubbles”) couldn’t
really be spotted with any degree of accuracy, and that investing too
much effort in that process was a fool’s game. Cleaning up after a bubble
had unexpectedly burst would, in his view, be more effective than trying
to guess when one might have formed. Bernanke, who had to supervise
one such cleanup, may now disagree on that point, but he evidently still
concurs that bubbles are not reliably identifiable before the fact. Yellen
does not quite share that view.
In a speech to the International Monetary Fund in Washington,
D.C., this past summer, Yellen acknowledged that “[p]olicymakers failed
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to anticipate that the reversal of the house price bubble would trigger
the most significant financial crisis in the United States since the Great
Depression.” But responding to the familiar argument that the housing
meltdown of 2008 was caused largely by her predecessor’s policy of keeping interest rates too low for too long, Yellen also said this:
A tighter monetary policy would not have closed the gaps in the
regulatory structure that allowed some SIFI’s [systemically important financial institutions] and markets to escape comprehensive
supervision; a tighter monetary policy would not have shifted
supervisory attention to a macroprudential perspective; and a
tighter monetary policy would not have increased the transparency of exotic financial instruments or ameliorated deficiencies in
risk measurement and the risk management in the private sector.
Nor did she leave any doubt as to her own priorities:
Monetary policy faces significant limitations as a tool to promote
financial stability . . . efforts to promote financial stability through
adjustments in interest rates would increase the volatility of inflation and employment. As a result, I believe a macroprudential
approach to supervision and regulation needs to play the primary
role.
Though her speech employed the arcane terminology that central bankers use among themselves, it was still front-page news in the financial
press and (to some extent) beyond. “Macroprudential” has certainly become a buzzword in central-bank circles. Hardly used before 2008, the
term now shows up constantly in conferences, seminars, and policy
papers. In econ-speak, the prefix “macro” refers to an entire economic
system, in contrast to “micro,” which suggests an analysis that focuses
on an individual firm. A “macroprudential approach” to supervision
and regulation, therefore, refers to overseeing the state of the entire financial system. It suggests an approach that aims to manage the system
as a whole, instead of a responsive approach to problems in the system.
For regulators, this has to be heady stuff.
In advocating greater supervision (often the role of other government
agencies) as a substitute for tighter money (the traditional purview of
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the central bank), Yellen has staked a claim to considerable additional
turf, even beyond the Fed’s already expanded portfolio. Perhaps she is
right that additional supervision, rather than tighter money, would have
been needed to head off the 2008 housing meltdown, but surely some
of the most important regulatory lapses in the build-up to the crisis
involved powers necessarily beyond the reach of the Federal Reserve.
There was, for instance, a lack of any serious attempt to tighten the
eligibility requirements for home loans covered by mortgage insurance.
The two “government-sponsored entities” most responsible for housing
finance — Fannie Mae and Freddie Mac — made no attempt to stem the
trend toward ever more permissive underwriting policies for mortgage
loans, and had in fact been pushed by Congress for two decades to
proceed in exactly the opposite direction in an effort to broaden home
ownership. There was also a failure to oversee the financial-derivatives
market. When Brooksley Born, as chair of the Commodity Futures
Trading Commission, proposed in 1998 that the CFTC write rules to
bring some order into the chaos of that market, she was opposed not
just by Alan Greenspan at the Fed, but also by then-Treasury secretary
Lawrence Summers, former Treasury secretary Robert Rubin, and SEC
chairman Arthur Levitt. And there was the monopoly of the three
credit-rating agencies. Standard and Poor’s, Moody’s, and Fitch gave
Triple-A ratings (equivalent to those of U.S. Treasury obligations) to all
sorts of collateralized debt obligations. Perverse incentives for borrowers
to seek these inaccurate ratings, and for rating agencies to grant them,
were built into the system.
None of this could have been prevented by the Fed — not with the
powers it had in 2007 and not with the powers it has today. Yellen’s call
for a “macroprudential” role for the central bank would seem to suggest
she wants such powers, or at least a role for the Fed in determining how
such powers are exercised by others.
To head off the threat of financial instability, then, Yellen says that
the Fed ought not be quick to exercise a tool that is firmly within its control (monetary tightening), but that it should employ a variety of other
tools involving tighter regulations — most of which have not traditionally been within its control. If she is right, either the Fed must access and
learn to wield powers that had formerly been handled by others, or the
Fed must convince those others to deploy those powers more reliably
themselves — and to do so on the central bank’s timetable.
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The Fed faces another hurdle in applying stricter regulation to curb
excessive risk-taking. In conjunction with the Federal Deposit Insurance
Corporation, the Fed has always required banks to comply with their
loan-underwriting standards and capital requirements. However, both
agencies have discretion in interpreting those rules, and examiners often become stricter after there have been some bank failures. Since an
increase of such failures almost always coincides with general economic
weakness, a downward spiral can ensue: More failures lead to stricter application of the rules, which makes banks more reluctant to lend, which
in turn leads to greater economic weakness and still more bank failures.
So the Fed has been known to counteract that spiral with a policy of
“regulatory forbearance,” which is a fancy way of saying that sometimes
examiners should be encouraged to cut regulated entities some slack and
not make banks even more afraid to lend money than they already are.
If the Fed assumed this mindset, lower interest rates for the purpose
of stimulating economic activity would go hand in hand with lighter
regulation. But in the macroprudential approach that Yellen outlined
to the IMF, lower interest rates are to be accompanied by heavier regulation. Putting regulation and supervision at the core of the Fed’s mission
could thus lead to significant tension with its more traditional purpose
of managing the money supply.
These problems are, of course, not unknown to Fed officials. Stanley
Fischer, the current vice chairman of the Federal Reserve, experienced
some of them directly during his recent tenure as chairman of the Bank
of Israel (that nation’s central bank). Faced with rapidly escalating housing prices in Israel in 2010, Fischer turned to regulatory, rather than
monetary, actions. “The success of these policies was mixed,” Fischer
told a conference held at the Swedish Ministry of Finance in Stockholm
this summer. He particularly cited political problems: “[H]ousing is a
sensitive topic in almost every country,” and “coordination among different regulators and authorities can be complicated.” Noting that he
was speaking for himself and not for the Federal Reserve System, Fischer
agreed that macroprudential policy has a place in the central bank’s
toolkit, but his endorsement was decidedly qualified.
While Fischer cautioned that other agencies may resent the Fed’s encroaching on their turf, Yellen has already experienced pressure from the
opposite direction — those who want the Fed to use its newly claimed
regulatory power even more aggressively than it already has. Consider an
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exchange between Yellen and Massachusetts senator Elizabeth Warren
after Yellen testified before the Senate Banking Committee in July.
Before her election to the Senate, Warren had overseen the establishment of the Consumer Finance Protection Bureau and was perceived as
a staunch supporter of Yellen’s combination of easy money and tighter
regulation. Yet when Warren began asking about the Fed’s lack of aggressiveness in monitoring the complex capital structure of the largest
banks, her criticism of the Fed turned unexpectedly harsh: “I have to
say, Chair Yellen, I think the language in the statute is pretty clear . . .
including forcing these financial institutions to simplify their structure
or forcing them to liquidate some of their assets. In other words, break
them up.”
The previous week, Stanley Fischer had been speaking to a group
in Cambridge, Massachusetts, about the notion of simply breaking up
the largest financial institutions. “There is no ‘simply’ in this area,” he
said. “[A]ctively breaking up the largest banks would be a very complex task, with uncertain payoff.” The same can be said more generally
about Yellen’s ambitions to see the Fed become a supervisor of the detailed workings of the financial system, rather than a stabilizer of the
background conditions in which it functions. As it becomes more of a
regulator, the Fed will face intense pressure from all sides, and its claims
to independence will grow more difficult to sustain and support.
In a recent, highly favorable profile of Yellen in the New Yorker, author Nicholas Lemann concluded on a cautionary note: “Yellen is an
economist. She has to become a politician.” Because she has staked out
such expansive and politically sensitive territory, with so little precedent
to rely upon, Lemann is probably right: Yellen will need considerable
political acumen to pursue her chosen course.
I n t er na l Consensus
Yellen will need to call upon those skills not only in her interactions
with the political system but also in her management of the Federal
Reserve System itself. Unlike the Supreme Court, where even 5-4 decisions are taken to speak for the institution and tend to remain the law
of the land for many years, the Fed’s credibility suffers quickly from
fragmented decisions. The central bank ultimately relies on market expectations that a declared policy will be maintained long enough to
bring about the desired results. If markets don’t believe the policy will
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be maintained, they will act accordingly, and the policy may as well not
exist at all.
The key group of decision-makers within the Fed is the Federal Open
Market Committee, which consists of 12 members — the seven members
of the Board of Governors of the Federal Reserve System, the president
of the Federal Reserve Bank of New York, and four of the remaining
11 regional Reserve Bank presidents, who serve one-year terms on the
FOMC on a rotating basis. When the Fed chair has a comfortable majority on the committee, as is almost always the case, even potential
dissenters can usually be persuaded to concur for the sake of institutional solidarity and systemic stability.
Fed watchers are therefore always on the lookout for internal fissures
on the FOMC. Though they are modest at the moment, some such fissures are evident now. One of the committee’s rotating members this
year is Richard Fisher, president of the Dallas Federal Reserve Bank.
Never shy about expressing his opinions, he took up several controversial aspects of Fed policy in a speech at the University of Southern
California on July 16. He said, for instance:
There is a lot of talk about “macroprudential” supervision as a way
to prevent financial excess from creating financial instability. My
view is that it has significant utility but is not a sufficient preventative. Macroprudential supervision is something of a Maginot line:
It can be circumvented.
Fisher was especially concerned about the Fed’s appearing politically pliant:
[W]e must avoid erring on the side of coddling inflation to compensate for the inability of fiscal and regulatory policymakers in
the legislative and executive branches to do their job. . . . We must
all, Federal Reserve principals and staff, and ordinary citizens
alike, continue to protect the independence of the Fed and its
ability to be a political nuisance.
Despite such reservations, Fisher has been inclined to vote with the majority of the FOMC to hold rates down. In fact, at the committee’s July
meeting, the only dissenting vote was cast by Charles Prosser, president
of the Philadelphia Federal Reserve Bank. So far, Yellen has maintained
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a near consensus within the FOMC, in part because she has been more
successful at predicting the course of the economy over the last five years
than the inflation alarmists have been. That success has helped her to
persuade the hawks on the FOMC that, as the new chair, she is entitled
to the benefit of the doubt.
The FOMC may well continue to support the extension of easy money
coupled with strict regulation as the primary means of preventing a
destabilizing run-up in the price of assets. But in order for easy-money
policies to be sustained by intense regulation, one of two scenarios must
play out, and both pose a danger to the Fed’s autonomy over time. In
the first scenario, increased regulation will indeed take effect, but it
will originate from the traditional sources of such power — the Fed,
certainly, but also the Treasury, the SEC, the Justice Department, the
Federal Housing Administration, and the FDIC. In effect, the Fed will
have invited greater regulation of the industry whose health has been its
primary responsibility, but that regulation would largely be conducted
by others. This would surely mean a new role for the Fed, one requiring
the central bank to, at least implicitly, take a new place in our system
of financial regulation — a more internal and less independent role.
Although it would certainly threaten the Fed’s independence, this scenario is the less troubling one.
The second scenario poses a different and even greater threat to the
Fed’s independence. If the central bank does accumulate additional regulatory power, as the more expansive interpretations of Dodd-Frank
now suggest it should, the Fed’s own examiners could, for instance, redetermine capital structures, reassess the quality of assets that were used
as collateral, and restrict lending in sectors of the economy that had
become too speculative. This would be a truly astonishing expansion
of the Federal Reserve’s power and role. And in today’s Washington,
just how long would such an accretion of power last? How long would
it take for opponents of near-zero interest rates to form alliances with
those who resent the Fed’s usurpation of prerogatives that had once
been theirs? How long could the Fed’s independence survive?
It is still not entirely clear which of these broad scenarios the Federal
Reserve will pursue. But it has been perfectly clear for some time that the
central bank is expanding its power and role. And Washington’s power
centers — most notably Congress — have already begun to respond.
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Congr e ssiona l Suspicion
In 2013, Republican senators Bob Corker and David Vitter introduced a
bill to partially restore the law governing the Federal Reserve to its pre1978 status. That was the year Congress passed the Humphrey-Hawkins
Act, giving the Fed its “dual mandate” to maintain both stable prices
and full employment. Senators Corker and Vitter believe the country
was better off when the Fed stuck to its original purpose and focused
solely on price stability, which, they argued, in itself would strengthen
the economy and help increase employment. They also noted that central banks in most democratic countries officially focus solely on price
stability, as does the central bank of the European Union. Although
both senators are members of the Banking Committee, as Republicans
they probably didn’t expect their “Single Mandate” bill to make much
headway in a Democratic-led senate. It didn’t.
The House of Representatives has been controlled by Republicans
since 2011, however, so it is not surprising that it has witnessed
somewhat more activity on proposed Fed legislation. Congressman
Kevin Brady, chairman of the Joint Economic Committee, proposed a
bill in 2013 to create a “Centennial Monetary Commission” that, on the
100th anniversary of the original bill that created the Federal Reserve
System, would recommend changes to the structure of the Fed. Perhaps
those changes would be similar to the Corker-Vitter proposal, or maybe
the commission would update one of several older proposals that would
have required extensive congressional audits of Fed proceedings. The
commission might even recommend something more radical (Brady has
also introduced legislation to restore the gold standard, for instance). In
any event, the Centennial bill didn’t make much headway either.
So in the past year, the House has tried a different tack. The House
Financial Services Committee proposed (on a nearly party-line 32-26
vote) major changes to the way the Fed does business. The centerpiece
of the “Federal Reserve Accountability and Transparency Act of 2014”
is a requirement that the Fed must articulate a clear and concise rule to
guide its monetary-policy decisions. The rule would be of the Fed’s own
choosing and could be changed as the Fed saw fit — but only in accordance with regular, orderly, and transparent procedures.
The bill is clearly aimed at curbing the Fed’s ad hoc expansions of its
power and role. “Rules-based” monetary policies are hardly new, and,
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whether by statutory requirement or customary practice, rules with
varying degrees of rigidity have guided Federal Reserve Boards in the
past. Indeed, it is difficult to see how Paul Volcker could have muscled
through his drastic monetary tightening in 1981 without referring to a
rule for limiting the money supply. Some observers said that any such
rule was really of Volcker’s own devising and so was hardly better than
arbitrary action, but a number of economists have argued that complex
yet predictable rules have in fact restrained the Fed’s power over the
years and enhanced its transparency.
In his exhaustive History of the Federal Reserve, published in two
volumes in 2002 and 2010, economist Alan Meltzer refers to two such
rules for base monetary growth — one that carries Meltzer’s own name
and another originated by economist Bennett McCallum — which he
believes have implicitly guided Fed decisions over the years. Meltzer also
mentions a rule that is far better known and relates directly to interest
rates: the Taylor rule.
Stanford’s John Taylor, after studying decades of Fed monetary policy, has devised a formula that he believes best determines a reasonably
neutral rate of interest that can gently guide the economy away from
sharp inflationary or deflationary movements. His formula is a complex
equation that takes into account real economic growth, the nominal
(inflation-adjusted) short-term interest rate, and an imputed “natural”
short-term interest rate. Taylor claims that his research describes how
the Fed has in fact often operated — and also shows what has happened
when the Fed has departed from its own best practices.
Unsurprisingly, Taylor is a strong backer of the proposed Transparency
and Accountability Act, as is his eminent Hoover Institution colleague,
former Secretary of State George Schultz. Equally unsurprisingly,
Janet Yellen told a congressional committee that any bill attempting
to constrain monetary policy by the imposition of a fixed rule would
be a “grave mistake.” She disdains mechanical formulas in general and
the Taylor rule in particular — which, she said, would “significantly
understate the case for keeping policy persistently accommodative in
current circumstances.”
At the moment, even many economists who believe that Fed policy
is too accommodative have doubts about applying a formula, whether
Taylor’s or anyone else’s. The Transparency and Accountability Act has
little chance of passage, even in the new Republican Congress, and no
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chance of winning President Obama’s signature. But congressional interest in imposing such restraints on the Fed’s growing power is likely
to persist. And the Fed’s independence will be further threatened (and
likely to draw further attention from Congress) because of the central
bank’s role in the management of the national debt — which is also
likely to grow increasingly problematic in the years to come.
T he Fed a nd t he Debt
In August 2013, the value of government securities owned by the Federal
Reserve crossed a striking milestone: $2 trillion, nearly as much as the
amounts held by the nation’s next two largest creditors, China and
Japan, combined.
Years ago, before foreign creditors owned so much of our debt, warnings about excessive national debt were met with the response that we
shouldn’t worry since “we owe it to ourselves” — meaning the debt was
mostly owned by American citizens who held Treasury securities. We
now once again mostly “owe it to ourselves,” but in a very different way:
Our debt is coming to be held not by American citizens, but by the nation’s central bank.
When a central bank lends money to the sovereign country in which
it resides, one piece of paper is swapped for another, but both ultimately
are backed by “the full faith and credit” of the same entity. The artifice
inherent in this transaction becomes especially worrisome as the size of
the overall national debt increases. As the debt grows, the cost of interest
on that debt becomes an enormous burden on the government’s budget,
and the potential of that burden to grow rapidly if interest rates were to
rise becomes a dangerous threat. America’s national debt now stands at
about $18 trillion, which means that the government could face an additional $500 billion expense if interest charges were to increase by just a
few percentage points — and even at that point, rates would still be well
below their historical average.
This means that the Treasury has become extraordinarily dependent
upon the Federal Reserve’s purchases of its debt at very cheap rates. In its
role of market-maker, the Fed drives down the price that everyone else
pays. On the portion the Fed holds in its own accounts, it remits over 90%
of the interest back to the Treasury. Given the degree to which the federal
debt has been monetized by the central bank, it may be just a matter of
time before Congress holds hearings to determine if there should be some
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limit — either as a percentage of GDP or an absolute amount — on the
portion of the outstanding government debt that the Fed can hold.
If Congress did take action, it would not be breaking entirely new
legislative ground. In 1935, Congress prohibited direct purchases of federal debt by the Fed, requiring that Treasury obligations originally be
purchased on the open market by private dealers. That prohibition was
temporarily suspended in 1942 to aid the war effort. In 1947, Marriner
Eccles, the long-serving Fed chairman (for whom the Federal Reserve
Building in Washington is named), argued before Congress that the
prohibition on direct purchases should be permanently abandoned because it served only to raise transaction costs. (In 1947, the Fed was still
required to maintain a specific interest-rate peg for short-term Treasury
notes.) So, as Eccles told a Senate committee, it didn’t make much practical difference to the Treasury whether the Fed bought these notes
directly from the Treasury or indirectly through third parties. Congress,
believing it should do something to obscure the loop between the Fed
and the Treasury, concluded over Eccles’s objections that the prohibition
on direct purchases would be reinstituted in 1950. (The exemption from
the prohibition on direct purchases was renewed every few years until
the 1980s, effectively vindicating Eccles’s advice.)
Eccles was, of course, also unhappy about that interest-rate peg. He
tried unsuccessfully to free the Fed from the obligation to support the
purchase of treasury bills at a specified rate, at one point calling the practice “the greatest potential agent of inflation that man could contrive.”
The Fed’s next chairman, William McChesney Martin, succeeded where
Eccles had failed; in 1951, the interest-rate peg was finally removed. In
fact, that “Treasury-Fed Accord” marked the beginning of the truly independent Federal Reserve. Since its origin in 1913, the Fed had been
slowly gaining greater autonomy from the Treasury department, but
no one could seriously argue that central-bank policy was not merely
an adjunct of fiscal policy unless the interest-rate link between the two
entities were completely severed.
If years of accommodative Fed policy now continue to cement a symbiotic relationship between a Treasury department that reflexively seeks
cheap money and a Federal Reserve that reflexively maintains low interest rates, the Fed may unwittingly subordinate itself to the Treasury yet
again. In this way, too, current trends threaten to seriously undermine
the Fed’s independence.
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Steve Stein · Saving the Fed from Itself
Congress would be right to worry about the growth of such a link
between fiscal and monetary policy and about the role of the Fed in the
management of the national debt. But what could Congress do? If the
Fed were carrying out policy with which President Obama concurred,
wouldn’t he simply veto any measure to exert any new Congressional
authority over the Fed? Maybe not — especially if that legislation were
folded into a debt-ceiling bill.
To be sure, the GOP’s recent forays into that legislative territory have
been both inept and naïve. Its manufactured crises over the debt ceiling
and government shutdowns caused more anguish for its friends than for
its opponents. When President Obama flatly refused to negotiate over
conditions for paying bills that Congress had already incurred, he held
the rhetorical high ground (at least after admitting he wrongly took the
opposite stance as a senator). Every time he reiterated his insistence that
Congress send him a “clean” debt-ceiling bill, he looked a little more
presidential. And every time Republicans attached extraneous provisions to a debt-ceiling bill, they looked a little more irresponsible.
But if the GOP studies the origins of the debt ceiling — in the Second
Liberty Bond Act of 1917 — they will see this is not necessarily the toxic,
self-destructive weapon they’ve made of it. In 1919, after World War I had
ended sooner than expected, the maximum allowable federal debt was
$43 billion, though the actual debt never exceeded $26 billion. This was
actually a key point of the debt ceiling: The legislation wasn’t a redundant ratification of existing indebtedness but a means of allowing the
Treasury to borrow at maturities longer than might be necessary to retire the debt. Then as now, both long-term and short-term interest rates
fluctuated, so if it made sense to take advantage of low long-term rates,
the Treasury needed the tools to do so. For over two decades after the
first debt-ceiling bill was passed, the Treasury was authorized to borrow
more than the debt the federal government actually owed.
That kind of approach could be the basis upon which a contemporary debt-ceiling bill might be crafted. The bill would not foolishly
attempt to set a maximum borrowing amount that was less than what
had been authorized to be spent. Rather, it would address the composition of the debt, including the amount that could be monetized by
central-bank operations. No president could convincingly claim that
this was not a “clean” debt-ceiling bill, for the legislation would go to
the very heart of the question of how government is properly financed.
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Congress, for example, could write debt-ceiling legislation that measures whether the national debt exceeds a stated percentage of nominal
GDP and, if it does, restricts the Fed from holding more than a specified
fraction of that debt. A sensible Congress would assure that any such
fraction would be in line with historical norms, but the mere existence
of any upper limit on debt monetization would speak volumes.
T he I ndependen t Fed
On its surface, such a change in the Fed’s role in managing the debt
would seem to restrict its independence. But since it would be a restriction on the Treasury’s efforts to recruit the Fed into its management
of fiscal policy, the change would more likely increase the Fed’s independence. Sober limits on the regulatory power of the Federal Reserve
would do the same, as would a careful and gradual return to the Fed’s
role as the manager of general monetary policy, rather than as the
supervisor of the entire financial system.
Public institutions are best able to fend off incursions against their
independence when they demonstrate a capacity for restraint and intelligent control of themselves. Historically, the Federal Reserve System has
been extraordinarily skillful in this regard. By operating the monetary
levers with a conspicuous degree of disinterest toward any particular
political agenda, the Fed has avoided the taint of partisanship that killed
the First and Second Bank of the United States in the nation’s early years.
In order to retain its autonomy and its respect, the Fed must convince critics that it is not becoming an ideological institution, that it is
not becoming cavalier toward the possibility that its policies can distort
financial markets, and that it is not becoming overconfident that such
distortions can be neutralized with ever-stricter regulation. Markets
could well see such a combination of arrogance and naïveté as a threat
to their very existence.
The Federal Reserve, with its $4.5 trillion balance sheet, has assumed
more responsibility for the operation of the economy than ever before.
Restoring its role to one that is more akin to that of a traditional central
bank will not be easy. It will require all the political acumen and professionalism that Janet Yellen seems now to be devoting to the opposite goal.
But unlike the aim of minimal monetary restraint and maximal regulatory
aggressiveness for the Fed, it would be both achievable and worthwhile.
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