August 17, 2010
The Federal Reserve’s ability to make independent policy decisions sets it apart from other government agencies. Why do we allow this departure from our usual democratic procedures? Why have we chosen to give so much power to a small group of people at the Fed, a group that can set monetary policy as it pleases without worrying about how voters might react? One reason is to prevent short-run political considerations from interfering with the pursuit of policy that is best for the economy from a long-run perspective. The policies that maximize the chances of winning the next election aren’t always the best policies when a longer horizon is adopted. Another reason is the ability to act quickly. Congress may not have the capacity to react fast enough in the face of a developing financial crisis.
However, independence from political influence doesn’t mean that the Fed’s policies will be free from political controversy. When the Fed takes advantage of its independence and adopts unpopular policies consistent with its long-run perspective, we should expect the Fed to come under considerable political heat. The design of the system allows members of Congress to deflect criticism away from themselves so that the Fed’s pursuit of long-run objectives does not cost them votes. They can even gain favor, sometimes disingenuously, by taking the side of those affected by the Fed’s decisions.
Thus, the fact that the Fed has taken so much criticism from members of Congress for its actions during the crisis should not be surprising. What is surprising, however, is the degree to which the Federal Reserve’s independence was threatened as a consequence, and the speed at which it happened. This should make us much more pessimistic about the Fed’s ability to control inflation in the long run.
If the government doesn’t put its finances on a sustainable path, which first and foremost means getting the growth in health care costs under control, there will be pressure on the Fed to monetize the debt.
The threat to the Fed’s independence is connected to the projected unsustainable rise in government debt over the next several decades. If the government doesn’t put its finances on a sustainable path, which first and foremost means getting the growth in health care costs under control, there will be pressure on the Fed to monetize the debt, that is, to print new money to buy back the government bonds held by the public.
Suppose that politicians continue to drag their feet on the health care cost issue until the point that financial markets react negatively. This isn’t a problem presently, and bond markets show no sign of worry yet, but it is a long-run concern. If these concerns are realized, politicians may conclude, rightly, that the amount of outstanding government debt is the problem. But they might also conclude, wrongly, that the solution is for the Fed to print new money and buy up these problematic assets, particularly since this solution takes the pressure off of Congress to increase taxes or cut spending to deal with the problem. The debt problem appears to be solved through monetization, and Congress can blame the resulting inflation on the Fed.
This wouldn’t be worrisome if the independence of the Fed could be relied upon; in fact some worry that the Fed is too hawkish on inflation, but recent events show how fast things can change for the Fed when Congress is unhappy. In the end, the Fed didn’t lose all that much autonomy in the reform bill that passed Congress, but the message was clear – when Congress speaks the Fed had better listen or the rules will change. If and when pressure to monetize the debt does come, it will be harder than before for the Fed to resist it. And if it does resist, the rules could be changed quickly to take away some of its independence.
If Congress wants to take more responsibility for monetary policy, it has the authority to do so, but I think that’s a mistake. They will get the blame when things go wrong and little credit when things go right. It’s better to leave the Federal Reserve as a target for criticism.
It’s also better for the economy to keep the short-run considerations of Congress from having too much influence over policy, and this is much more important than who gets the credit or blame. I’d prefer that the Congress set the rules – the Fed’s mandate to stabilize prices and employment is an example of the type of rule I have in mind – and then let the Fed pursue those goals independently.
While the Fed doesn’t always make the best choices, especially in hindsight, I have no doubt – none at all – that Congress would be worse.
This is not an argument that the Fed has been perfect in the past; there’s plenty to criticize about the Fed’s reaction to the financial crisis. I think, for example, that the Fed has paid too much attention to the prospect of inflation and not enough attention to the reality of high unemployment, and a reexamination of its mandate is in order. But while the Fed doesn’t always make the best choices, especially in hindsight, I have no doubt – none at all – that Congress would be worse.
But whatever Congress does, the rules need to be made clear before the next big financial event hits the economy. It’s counterproductive to have uncertainty over the Fed’s authority and mission when there is need for action and for reassurance. Congress needs to decide what the Fed’s mandate is and how much independence the Fed should have to pursue it. It then needs to honor whatever degree of independence the Fed has been granted, especially during times of crisis when the Fed may be forced to do unpopular things it thinks are best from a long-run perspective. The Fed won’t always get it right, but it’s better than the alternative.
Mark Thoma is a Professor of Economics at the University of Oregon. He blogs daily at