In the GOP’s latest shot across the bow of the independent Federal Reserve, the House on Thursday will complete work on a bill designed to grant Congress enhanced oversight and influence over monetary policy and literally dictate a formula for setting interest rates in the future.
The Fed’s soft-money policies that kept interest rates at rock bottom throughout the worst of the economic crisis and recovery have frequently drawn sharp fire from congressional conservative including House Financial Services Committee Chair Jeb Hensarling and Ways and Means Committee Chair Kevin Brady who have long fretted about a return to inflationary times.
Hensarling also complained to Chair Janet Yellen recently that the Fed had been granted “vast, new sweeping regulatory powers” by the 2010 Dodd-Frank financial regulation overhaul despite its contribution to the last financial crisis. “The Fed must not be allowed to shield its vast regulatory activities from the American people and congressional oversight by improperly cloaking them behind its traditional monetary policy independence,” Hensarling said during a hearing.
The House Republicans’ solution to the problem is a complex bill dubbed the Fed Oversight Reform and Modernization Act (FORM) – a measure likely to pass the House today that Yellen warns would be a “grave mistake” that could seriously harm the economy and once again drive up unemployment.
“The bill would severely impair the Federal Reserve’s ability to carry out its congressional mandate and would be a grave mistake, detrimental to the economy and the American people,” she said in a letter to House Speaker Paul D. Ryan (R-WI) and Minority Leader Nancy Pelosi (D-CA).
Among other things, the GOP bill that emerged from the Financial Services Committee last week on a straight party-line vote, would require the Fed to be more “transparent” about the stress tests it requires the nation’s largest banks to pass each year. It would require Fed employees to abide by the same ethical requirements as other federal financial regulators. And it would place new restrictions on the Fed’s ability to make emergency loans during periods of financial crisis.
But by far the most dire and controversial measure would force Fed officials to adopt a mathematic or formulaic approach to setting interest rates in the future that essentially would put one of the Fed’s most important tasks on auto-pilot. The bill would require Yellen and other Fed board members to choose a monetary policy strategy and communicate it to the public whenever it makes decisions regarding interest rates and the nation’s money supply.
Instead of basing the Fed’s most critical monetary decisions on money supply, the relative strength of the dollar, the bond market, the latest unemployment figures and consumer-confidence indexes, Fed officials would essentially rely on a rule of thumb first devised by Stanford economist John Taylor in 1993.
The so-called Taylor Rule – which Fed officials and others have factored into their thinking over the years -- holds that if inflation is one percentage point above the Fed’s goal, rates should rise by 1.5 percentage points, according to David Wessel of the Brookings Institution. And if – in a recession for example – an economy’s total output is one percentage point below its fully capacity, rates should fall by half a percentage point.”
“It’s basically pretty simple,” said Wessel, the director of the Hutchins Center on Fiscal and Monetary Policy. “It says you look and make an estimate of what interest rates would be if things were normal. Then you look at how far you are from normal, both in terms of full employment and inflation. And you adjust some coefficient to allow to decide how much higher or lower interest rates should be.”
Under the GOP plan, the Fed would have to enunciate and closely follow a new strategy for deciding whether to raise interest rates. And any time they the policy makers vary from the formula, they would be subject to review – and second-guessing — by the Government Accountability Office (GAO) and Congress
“It would elevate this rule to a much higher profile in Fed decision making than it is now,” Wessel added. “It’s widely used by the Fed in calculations…. But this [bill] might make it harder for the Fed to be bold when it wanted to be bold, because it always would have to justify why it wasn’t doing what it promised it would.”
But Yellen and other staunch Fed defenders say the legislation would be a disaster that would hamstring monetary policy makers and destroy the Federal Open Market Committee’s fiercely guarded independence.
“Had the FOMC been compelled to operate under a simple policy rule for the past six and a half years, the unemployment experience of that period would have been substantially more painful than it already was, and inflation would be even further below the FOMC’s 2-percent objective,” Yellen said in her letter to the congressional leaders.
“Indeed, a recent study by Federal Reserve economists suggests that the current unemployment rate would still be above 6 percent and inflation would now be running somewhat below zero, if the FOMC had not taken the actions it did but rather had followed the reference rule and made it clear that it would do so in the future,” she added.
Karen Shaw Petrou, Managing Partner of Federal Financial Analytics, Inc., a private company, takes an equally dim view of the GOP legislation.
“I would concur with the Fed’s concerns about the formulaic approach,” she said in an interview. “And I think not only for the reasons they say…. We learned during the 2008 near-death financial crisis that monetary policy has significant impact, not only on macroeconomic growth but also on financial stability, for good or ill.”
“And the Taylor Rule approach doesn’t deal with that at all,” she argued. “It’s a very old-school way of thinking about what a central bank should do. And in my opinion that’s the kind of central banking that may well sow the seeds of a systemic crisis.”
She said that even if the rule works for macroeconomic growth, it could “so distort market incentives as to create exactly the kind of conditions in which even just a small spark can lead to a market freeze.”
Wessel agrees with other critics that some of the provisions, including second-guessing by the GAO, “could really make it hard for the Fed to be independent and creative.” While the bill is likely to pass the GOP-dominated House, Democrats are certain to block the measure in the Senate. And the White House has issued a veto threat.
But Wessel suggested that Yellen and other Fed members might have been more diplomatic in responding to the Republicans’ concerns.
“On this [bill], I think what the Fed has done is say no to everything, and they’re not willing to say, ‘We hear you and how about let’s do it this way,” Wessel said. “The Fed must think that if you give them an inch they’ll take a mile. And that critics of the Fed and Congress are not really interested in making the Fed more accountable, they’re just interested in scoring political points – and so why bargain with them?”