NEW YORK – While “not too surprising” there would be a move to restructure the Federal Reserve system after two years of turmoil, “some of the proposals to change the Fed’s structure are misguided and even pose serious risks to the health of our economy,” Federal Reserve Bank of Philadelphia President and Chief Executive Officer Charles I. Plosser told the World Affairs Council of Philadelphia today.
The current system allows policymakers “independence when conducting monetary policy but in return requires transparency and accountability to the American people,” Plosser said, according to prepared text of his remarks, which were released by the Fed.
He noted, financial market conditions have improved, and the Fed allowed most of its temporary special liquidity programs to expire on February 1. “Although we have yet to see robust employment growth, there are signs that labor market conditions are starting to slowly improve and it appears that a modest economic recovery has begun,” Plosser said.
And so, policymakers have turned their efforts to averting future crises. “Unfortunately, some initiatives would strike at the very foundations of sound and responsible central banking,” Plosser warned.
Among the threats to the central bank’s independence is the “Audit the Fed” amendment passed by the House of Representatives in December. Plosser said the amendment would allow any legislator to demand a Government Accountability Office “audit” of the Fed’s monetary policy decisions. He said the “audit” was not “in the usual accounting sense of the term, since the Fed’s financial statements and controls are already subject to extensive outside audits by the GAO and a public accounting firm.”
The amendment would be used to “investigate a monetary policy decision whenever any member of Congress opposes a decision to change interest rates. This would undermine the Fed’s credibility and its ability to conduct monetary policy in the long-term interests of the American public.”
He also spoke against “efforts to make political appointees out of the Reserve Bank presidents or members of their boards of directors.”
Such changes would be “counter to history and the principles of sound and responsible central banking,” Plosser said. Countries have increased the independence of monetary policymaking to shield it from short-term political influences. Countries with greater central bank independence “tend to have lower and more stable inflation without sacrificing employment or output, thus benefiting from more stable economies and better economic performance,” he said.
He said assaults on central banks are occurring elsewhere, including Argentina, South Korea, Japan, and Mexico. “These efforts, along with the proposals that would politicize the Federal Reserve here in the U.S., are deeply troubling,” Plosser added. “While many try to interpret these efforts as logical or inconsequential, they are not — they are misguided and potentially damaging to the nation’s economic well-being.”
He explained that many don’t understand what it means for the central bank to be independent. “Central bank independence means that the central bank can make monetary policy decisions without fear of direct political interference. It does not mean that the central bank is not accountable for its policies.”
Plosser said the Fed was designed policymakers wouldn’t be pressed to meet the short-term desires of the public and elected officials and could keep their eyes on the economy and wait since “monetary policy affects the economy with sometimes long and variable lags,” at least quarters, but perhaps years.
“Moreover, there can be a conflict between what monetary policy may be able to achieve over the short term versus its impact over the long term,” Plosser noted. “For example, in the short term, it might seem expedient or even desirable to try to spur economic growth and employment by setting excessively accommodative monetary policy. Yet, this will only lead to very bad economic outcomes in the long term — including higher inflation, higher interest rates, and an eventual tightening of policy to control inflation that may be detrimental to the economy. These outcomes would be inconsistent with the long-term goals set by Congress. Delegating the decision-making to an independent central bank that can focus on long-term policy goals is a way of limiting the temptation for short-term gains at the expense of the future.”
Plosser said the second reason central banks need to be independent “is to separate the authority of those in government responsible for making the decisions to spend and tax from those responsible for printing the money. This lessens the temptation for the fiscal authority to use the printing press to fund its public spending, thereby substituting a hidden tax of inflation in the future for taxes or spending cuts.”
Turning to the recent crisis, Plosser said that the Fed was faced with the challenge of firms “too big to fail,” and “the Fed greatly increased the size of its balance sheet and changed its composition, substituting less liquid, long-term assets, such as securities backed by mortgages guaranteed by Fannie Mae and Freddie Mac, for the short-term Treasury securities it typically held before the crisis. These policies have veered toward deciding how public money should be allocated across firms and sectors of the economy. I believe that if the government must intervene in allocating credit in this manner, such decisions properly belong to the fiscal authorities — not to the central bank. By making these unprecedented lending decisions, and at times being less transparent than we could have been, the Fed has opened itself up to criticism from various sources and has encouraged the idea that monetary policy decisions may be influenced by political or other special interests. This is not a healthy development.”
To that end, Plosser suggested, the Fed in the future “implement monetary policy using a portfolio that contains only Treasury securities, preferably concentrated in bills and short-term coupon bonds.”
When recovery gains strength and monetary policy begins to normalize, Plosser said, he’d support selling “some of the agency mortgage-backed securities from our portfolio rather than relying only on redemptions of these assets. Doing so would help extricate the Fed from the realm of fiscal policy and housing finance. It will take some time for the Fed’s portfolio to return to its pre-crisis composition, but we should begin taking steps in that direction sooner rather than later.”
He also urged the Fed’s 13(3) emergency lending authority “should be either eliminated or severely curtailed. Such lending should be done by the fiscal authorities only in emergencies and, if the Fed is involved, only upon the written request of the Treasury,” eliminating Fed participation in “bailouts” of individual firms or sectors.
Also, Plosser said, “we must work harder to enhance and improve the transparency of the Federal Reserve,” despite its gains in these departments in the past 20 years.
“The independence of the Fed or any central bank does not guarantee all policy choices will be wise or perfect — particularly in hindsight,” he said. “I will be the first to acknowledge, and during my academic career frequently pointed out, that the Fed has made its share of mistakes. The Great Inflation of the 1970s is a perfect example. Indeed, the cause of the Great Inflation stems directly from political pressures on the Fed to help finance the Vietnam War by creating money, which it did, and pressure to provide excessive and prolonged policy accommodation in the face of the oil shocks of the 1970s, which it also did. Thus, this was a failure of the Fed’s not exercising its independence to resist political pressure. Not one of our prouder moments. Yet economic theory and the historical record suggest that turning monetary policy and thus the printing of money over to the fiscal authorities or the political process would be worse. Indeed, I would ask those who think the Fed kept interest rates too low for too long in the early part of this decade to imagine the outcome had the process been more political. I doubt the result would have been that rates would have risen sooner or faster.”
