The Fed and Political Independence: It’s Complicated

Writing in the Wall Street Journal, Joseph Sternberg wonders whether the Federal Reserve is too insulated from politics. The Fed clearly failed by allowing the worst inflation we’ve seen in 40 years. Now, however, there are worries it’s veering too far the other way: “the central bank could cast the economy into a recession for no good reason” through excessive tightening. It seems the Fed is institutionally incapable of threading the needle.

Would making the Fed more accountable to elected officials help? Sternberg seems to think so. “Democrats and Republicans can be voted out of office if their preferred economic policies fail,” Sternberg explains. “Fed officials can’t be.” As a result, the Fed has become a law unto itself. This is unacceptable for a nation that takes constitutionally limited government seriously.

Sternberg discusses a proposal to increase political accountability by having state governors appoint Fed regional bank boards (which then appoint the regional bank president) as well as empowering “the US president to fire at will members of the Board of Governors.” These are major changes. In response to the criticism that this would politicize the Fed, he responds that the Fed is already politicized—and he’s indisputably correct.

Fed economists indeed skew heavily Democrat. And the policies they’ve pursued, especially with respect to racial unemployment gaps and climate change, are obviously partisan. Yet we should be cautious. Things can always get worse. Imagine if something like the ominously named Federal Reserve Racial and Economic Equity Act became law. Even more concerningly, politicians empowered in the way Sternberg suggests could simply pressure the Fed to do similar things without even passing a law. To some extent, these things are already happening. That doesn’t mean we should make it easier for them to happen even more frequently or intensely.

The Fed’s monetary and regulatory policies are predictably bad because of the incentives Fed decisionmakers confront. We need to find a way to improve incentives. Here are a few changes that Sternberg doesn’t consider:

Adopt a strict target rule. Congress should change the Fed’s mandate to focus solely on price stability. It should require the central bank to target the price level or nominal GDP (I prefer the latter). The Fed can choose the metric, but it must stick with it, and its leaders must be accountable for hitting the target on an ongoing basis. Failure should result in punishment, up to and including dismissal.

Ditch the floor system. Return to the corridor system. The Fed’s strategy of using interest paid on reserves to implement monetary policy gives it too much power. The Fed can arbitrarily increase its balance sheet, giving it power over credit allocation. In essence, the Fed pays banks not to lend, which incentivizes banks to keep larger reserve balances in their Fed accounts. But this means the Fed can create a large amount of high-powered money and use it to purchase favored assets, while sterilizing those purchases with interest payments so that the usual inflationary consequences do not follow. This whole endeavor is inappropriate. Central banks should be liquidity providers, not credit allocators. We should return to the older corridor system, where the policy interest rate (the fed funds rate) depended primarily on the supply and demand for bank reserves. The Fed may still pay interest on reserves, but it should be required to pay 25 to 50 bps below its federal funds rate target range.

No more lender of last resort. Close the discount window. The Fed is bad at emergency lending. It has proven unwilling or unable to sort out in real time which financial institutions are merely illiquid, as opposed to insolvent. The Fed doesn’t need to act as an emergency lender so long as it is providing an adequate amount of liquidity to the banking system. Let the market price and allocate emergency loans.

Keep regulation minimal. Instead of complicated regulations, such as risk-weighted capital standards, the Fed should focus on clear and simple rules. The most obvious is ensuring banks hold adequate reserves and have sufficient capital to back short-term liabilities. Beyond this, regulation becomes heavy-handed and clumsy. It does more harm than good. 

No more monetary and regulatory innovations without Congressional assent. The Fed needs Congress’s explicit permission if it wants to get involved in racial equity, climate change, or any other issue beyond its narrow mandate. The norm must become “that which is not permitted is forbidden.” The Fed has a hard enough job already. It has a barely adequate track record as a monetary policymaker and bank regulator. We don’t need it taking on even more complicated tasks. Still less do we want it to deteriorate into another social-justice outfit. Congress must ensure the Fed stays in its lane. There should be consequences to drifting.

In some ways, the proposals Sternberg considers are radical. But in others, they’re nowhere near radical enough. Getting more accountable personnel is desirable. But given the often-problematic incentives with voting and collective action, it’s entirely possible increased political control would make things worse. We should focus less on who’s allowed to run the Fed and more on what the Fed’s allowed to do in the first place.