Better Ways to Make the Fed Better
One of the likely implications of the new Republican majority in the House is that the crosshairs of reform have been leveled on the Federal Reserve, the nation’s central bank. Republican members – and many of the voters who elected them – continue to seethe over the bailouts of financial institutions during the recent crisis, and no government entity is perceived as being more responsible for the bailouts than the Fed. The initiation in November of a second round of quantitative easing – known as “QE2” – whereby the Fed will purchase some $600 billion in government bonds in an attempt to stimulate the still-fragile economic recovery by lowering interest rates, has further antagonized many Republicans who view such action as unauthorized and, therefore, unconstitutional spending that risks igniting runaway inflation. Controversial from the very day of its creation in 1913, the Fed – by way if its actions during and since the recent financial crisis – has inspired a level of animosity not seen since President Andrew Jackson abolished the Second Bank of the United States in 1832.
Long-time Fed critic Rep. Ron Paul (R-TX), the new chairman of the Domestic Monetary Policy and Technology subcommittee of the House Financial Services Committee – and author of the 2009 New York Times bestseller End the Fed – is expected to use his new authority to pursue the goal of requiring an annual Government Accountability Office audit of the central bank, its operations, and monetary policy decisions. Meanwhile, Rep. Mike Pence (R-IN) recently introduced legislation to repeal the Fed’s mandate to pursue “maximum employment,” which Congress added to the Fed’s original mandate of price stability in 1977. Senator Bob Corker (R-TN) introduced similar legislation in the Senate last year.
Efforts to reform the Federal Reserve and its responsibilities are understandable and even appropriate following the tumultuous events of the past two years. But auditing the Fed’s monetary policy decisions or narrowing its mandate risk undermining the Fed’s effectiveness as the central bank rather than enhancing it.
The Fed is arguably the most transparent central bank in the world. Federal Reserve Board governors and Reserve Bank presidents deliver frequent public speeches and Congressional testimonies on economic circumstances and their implications for policy. The Fed submits an extensive report to the Congress twice each year on the economy and monetary policy. The Federal Open Market Committee (FOMC) – the Fed’s monetary policymaking arm – releases a statement after each of its meetings explaining the Committee’s policy decision and reports the vote on that decision. The FOMC also publishes the minutes of each meeting three weeks later and provides, with a lag, full meeting transcripts. Finally, the Fed regularly publishes detailed information regarding the size and structure of its balance sheet and the special liquidity facilities introduced during the recent crisis.
One is left to wonder – short of broadcasting FOMC meetings on C-SPAN – how much more transparent the Fed could be. More fundamentally, it is difficult to understand how more intrusive investigation of monetary policy can be consistent with price stability, when innumerable academic studies and hundreds of years of experience in countries around the world have made clear that the relative independence of a central bank and its effectiveness in combating inflation are closely correlated.
Similarly, it is difficult to see the appeal – political or substantive – of efforts to drop the Fed’s maximum employment mandate with the nation having endured an unemployment rate north of 9 percent for almost two years now, and with forty percent of unemployed Americans out of work for six months or longer. More fundamentally, as Marc Sumerlin, a former deputy director of the National Economic Council under President George W. Bush demonstrated in a recent Wall Street Journal Op-Ed, there is no evidence to suggest that a singular focus on price stability would have produced tighter monetary policy over the past 10 to 15 years. Indeed, focused solely on price stability – the challenge most often having been to avoid falling prices – Fed policy might well have been even more stimulative over the period.
From January 1995 to mid-1999, the Fed reduced short-term interest rates from 6 to 4.75 percent even as real economic growth averaged 4 percent and the NASDAQ soared 233 percent. Over the same period, the ratio of household net worth to disposable income surged 33 percent – an unprecedented acceleration. Similarly, the Fed reduced the fed-funds rate to 1 percent in 2003 and kept rates very low until the summer of 2006. Over the period, aggregate credit rose steadily to more than 350 percent of GDP from 225 percent, and housing price-to-rent ratios departed wildly from historical norms as home prices surged in some areas of the country as much as 15 percent per year. In both periods, the FOMC referenced low or falling prices as the reason for reducing rates. Had the Fed’s mandate included analysis of debt levels and asset prices, monetary policy would presumably have been tighter.
These observations suggest that the Fed’s mandate should not be narrowed, but broadened. Specifically, in making monetary policy decisions the FOMC should pursue maximum employment in a context of price stability, while seeking to avoid unnatural or dangerous distortions in debt levels or asset prices, or words to that effect. When asked about asset bubbles while testifying before Congress, Chairman Ben Bernanke has been quick to point out that avoiding asset bubbles is not part of the Fed’s mandate from Congress. In other words, it’s not his job. Well, Congress might make it his job.
Another meaningful reform – or modernization – that would make monetary policy more responsive to the needs and priorities of a highly diverse U.S. economy would be to re-structure the system of regional Reserve Banks.
In establishing the Federal Reserve, policymakers constructed a system of 12 regional Reserve Banks presided over by a seven-member Board of Governors in Washington. The FOMC, created by the Banking Act of 1933 and revised by the Banking Act of 1935, is comprised of 12 members, including the Washington-based Governors and five of the regional Reserve Bank presidents on as rotating basis. This admittedly cumbersome system was deliberate – policymakers wisely sought to ensure that interest rate policy would reflect economic conditions and priorities from across the nation, and not be dictated to the rest of the nation from Washington, DC.
Thirty-seven cities applied in 1914 to the Reserve Board Organization Committee for one of the eight to 12 regional Reserve Banks stipulated by the Federal Reserve Act. While politics no doubt played a role in the distribution of the Banks – Senator James A. Reed of Missouri, a prominent member of the Senate Banking Committee, managed to get two (Kansas City and St. Louis) placed in his state – final placement of the 12 regional Reserve Banks generally reflected the distribution of population and economic activity across the nation at the time.
The result was a Federal Reserve System with a decidedly eastern tilt – eight of the 12 Reserve Banks east of the Mississippi River; six within 600 miles of Washington, DC, while 1,700 miles separate the San Francisco Reserve Bank from the next closest in Dallas.
America has changed since 1914. As of 2008, 41 percent of the U.S. population – and, presumably, a similar portion of economic activity – resides west of the Mississippi River. This simple metric suggests that if the interests and priorities of the entire nation are to be fairly represented in the FOMC’s monetary policy deliberations, at least five regional Reserve Banks should be located in western cities. Given the likely political difficulty of uprooting a Reserve Bank from its current location, the better option might be to expand the number of Reserve Banks to 14, placing the additional two in appropriate western cities.
The structure of the FOMC might also be amended to accommodate the additional Reserve Banks by increasing the number of voting Reserve Bank presidents from five to seven, producing an FOMC of 14 members split evenly between the rotating regional Reserve Banks and the Washington-based Board of Governors.
Whatever reforms Congress considers, potential changes must be deliberated with great care. President Jackson, a Jeffersonian in his hatred of the central bank, took tremendous satisfaction in killing “that monster bank” in 1832. In is worth recalling, however, that a severe financial panic ensued in 1837, which plunged the nation into a 5-year economic depression. Six more financial crises occurred over the next 70 years, culminating with the Panic of 1907, which led to the creation of the Federal Reserve.
The Fed is not a perfect institution and remains controversial. Reform of its structure and responsibilities may be appropriate and should be considered. But ultimately, America needs a strong, credible, and independent central bank.
John R. Dearie is Executive Vice President of the Financial Services Forum. The views expressed are his own.