Fed’s independence hangs in the balance
The threat of politicization hangs over the Federal Reserve Board like the Sword of Damocles. It’s Capitol Hill’s response to the Fed’s proliferation of new programs to unglue credit markets. The Fed’s innovations threaten to create enough acronyms to tax the limits of the alphabet.
Rep. Barney Frank, Massachusetts Democrat and chairman of the House Financial Services Committee, which oversees the Federal Reserve, has warned, “There is a problem with too much power going to an entity that is not subject to democratic powers.” The Fed should be “accountable to voters.”
Rep. Ron Paul, Texas Republican, has authored a Fed transparency bill calling for Fed audits. The bill has more than 200 co-sponsors, and the number is rising daily. It’s just a “first step,” Mr. Paul says.
Sen. Christopher J. Dodd, Connecticut Democrat and chairman of the Senate Banking Committee, which shares oversight responsibilities for the Federal Reserve System, also wants more Fed transparency as well as an evaluation and closer scrutiny of regional Federal Reserve banks.
Questions have been raised about the location of the regional banks and whether they should be more evenly distributed around the country and whether Senate confirmation should be required of Federal Reserve Bank presidents. Some in Congress are angry because the Fed won’t name the companies participating in its programs. And if the Fed gets new regulatory powers over the financial economy, that will inspire yet more attacks on its independence.
Some observers say the Fed already has slipped over the edge politically. The innuendo in German Chancellor Angela Merkel’s recent remarks was telling when she said, “We must return together to an independent centralbank policy.”
The Fed’s political conundrum has become deadly serious, and the stakes are high. Fed Chairman Ben S. Bernanke knew the risks when he and his colleagues on the Federal Open Market Committee (FOMC) embarked upon a bold new scheme to unlock credit flows, but they believed the risks were unavoidable. Financial markets were frozen, the economy was in deep trouble, and the Fed policymakers became convinced that bold new programs were essential to provide liquidity and stimulate economic growth.
Almost overnight, the macroeconomic Fed became the microeconomic manager, involving itself in the destinies of individual businesses, such as Bear Stearns Cos. Inc., Merrill Lynch & Co. Inc., American International Group Inc. and Citigroup Inc. Did the Fed go too far? Some analysts say yes and argue that at least part of the Fed’s cleanup work could have been handled by the Treasury Department.
There’s no question: Politicization of our nation’s central bank will seriously damage the effectiveness of monetary policy, the very heart and soul of the Fed’s mission.
Members of Congress and presidents are elected for relatively short terms and thus have short time horizons, but Fed policy of necessity is also based on long-term trends and goals. Imagine what would happen if greater political control over the Fed led to suspicions that the central bank was being prodded to push up inflation to cheapen the dollar in order to ease an unsustainable rise in the federal debt. Suspicion that the debt was being monetized because of polit- ical pressures would trigger a flight from the dollar and a sharp loss in its value, among other negative outcomes. The fallout would be disastrous.
Mr. Bernanke has clearly said the Fed will not monetize the debt. That’s believable as long as he remains Fed chairman. But his very declaration may have provoked some in Congress to step up their campaign to limit the Fed’s discretion and independence.
From what is not being said, one senses the Obama administration understands the risks of Fed politicization, or even its appearance, and will stay clear of making inroads into the Fed’s authority. Indeed, the questions being asked about the motives of legislators seeking to constrain the Fed and where it might lead are raising a specter that, ironically, puts pressure on the president to reappoint Mr. Bernanke — the image of independence — as chairman when his term expires in January.
Confidence in the future is a great asset that adds strength to the argument that the Fed should adopt a policy of explicit inflation targeting, which Mr. Bernanke favors. In addition to its economic merits, long-term targeting would be self-protecting.
Honest arithmetic tells us expected economic growth in the next decade will be insufficient to bring projected ratios of debt to gross domestic product down to acceptable levels, so taxes will have to be raised and entitlement programs cut back. Taxes alone can‘t be raised enough to reduce the debt ratio without doing serious injury to the economy. Members of Congress know this. Thus, a partial backdoor solution, via the hidden tax of higher inflation — if it could be blamed on the Fed — might seem to them an attractive choice.
How the Fed fares in the months and years ahead will depend very much on whether its new programs and policies prove effective. If they help save the day, there’s a good chance the Fed’s independence will remain intact. Let’s hope so.
Alfred Tella is former Georgetown University research professor of economics.