How will the Federal Reserve evolve during Donald Trump’s term as president? Presently, three of the seven positions on the Federal Reserve Board are vacant. These vacancies, along with the possibility of replacing Federal Reserve Chair Janet Yellen when her term ends in early February of next year, give Trump an opportunity to change how the Fed conducts both monetary and regulatory policy.
It is not yet clear if Trump will replace Yellen, and holding three of the seven Board seats does not give Trump appointees the clout they need to dominate policy decisions. So, for now, the policy is unlikely to change drastically. But that could change in one of two ways. First, if Trump does appoint a new chair, and if additional Board members decide to step down and are replaced with Trump nominees, they would have a much stronger hand. But unless Trump is able to appoint all seven Board members, the Regional Bank presidents, who hold five of the twelve votes on monetary policy, could still stand in the way of attempts to change how monetary policy is conducted.
There is the second-way policy could be changed. During the Obama administration, Republicans in Congress, with support from some members of the academic community, threatened to pass legislation forcing the Fed to follow a fixed policy rule when setting its target interest rate. The Fed would only be allowed to deviate from the rule in extraordinary circumstances. One such rule is the Taylor rule linking changes in the Fed’s target interest rate to changes in inflation and output.
Trump’s first nominee to the Federal Reserve Board, Randal Quarles supports this rule-based approach to monetary policy. Janet Yellen strongly opposes the rules-based approach, but if she is replaced I fully expect a push in this direction. If other members of the Board stand in the way, legislation from Republicans in Congress supported by Trump could force the Fed to adopt and follow a policy rule. Thus, if the Fed cannot be moved to adopt a policy rule through Trump appointments to the Board, it may very well be forced to do so through legislation.
There are reasons both for and against the Fed adopting a policy rule. The main argument against is that no rule can anticipate every contingency the Fed might face. When the Fed faces circumstances the rule does not anticipate, a rule prevents the Fed from taking this information into account when setting monetary policy. Thus, it limits the Fed’s ability to respond to changing economic conditions. The main argument for a rule comes from academic literature showing that rules can often, though not always, produce better economic outcomes.
But I want to focus on another reason to oppose a policy rule. A fixed policy rule undermines a key way in which interests are balanced in deliberations over monetary policy.
The Federal Reserve was created through a compromise of two competing visions of how monetary policy should be conducted. Republicans were wary of monetary policy in the hands of government and favored a system where decentralized private banks would set policy independent of the federal government. Democrats were wary of monetary policy being set by private bankers and favored a system where a government controlled agency sets monetary policy. The result was a system that attempted to balance these competing concerns.
This is evident in the structure of the Federal Open Market Committee – the committee that sets monetary policy. The committee includes the seven members of the Board of Governors plus a rotating list of five of the twelve Regional Bank presidents (the president of the NY Fed is a permanent member). Thus, if the Board is united, it has the votes to sway policy decisions. But when the Board is divided, as it would likely be with Trump and Obama appointees in roughly equal numbers, the Regional Banks have the power to determine how monetary policy is conducted.
A monetary policy rule takes away the power of the Regional Banks to cast dissenting votes except in “extraordinary times.” But what if the outcome of the rule is counter to the interests of the region they represent? Essentially, a rule – especially if forced by Congress – imposes federal will upon the Regional Banks. That is not how the system is supposed to operate. Interestingly, it is the supposed defender of private interests, Republicans, pushing for this change.
But the change is not needed. During normal economic times, the Fed already implicitly follows a rule. The Taylor rule captures most policy choices the Fed has made in recent decades. The exception was during the Great Recession, and that is what this debate is really about – the degree to which the Fed should be able to respond creatively to unusual economic events with programs such as quantitative easing, liquidity facilities, and keeping interest rates low for much longer than the Taylor rule suggests.
There is room to criticize the Fed’s response to the Great Recession. For example, in the Fed’s eyes recovery was always just around the corner, and at times the expectation that better times were just ahead delayed needed policy responses. But the overall policy was helpful and effective, especially given the failure of Congress to use fiscal policy to aid the recovery.
And that is where the irony lies. The very body that could not respond effectively with fiscal policy measures during the Great Recession, and in fact worked against recovery with austerity, would like to make it more difficult for the Fed to do its job even as they vote to remove safeguards that insulate the financial sector from another crisis. If Congress wants to improve economic policy, it should address its own dysfunction and leave the Fed alone.