Academic journal article Business Economics

What's Wrong with the Federal Reserve: What Would Restore Independence?

Academic journal article Business Economics

What's Wrong with the Federal Reserve: What Would Restore Independence?

Article excerpt

The actual degree of independence of the Federal Reserve has varied over the years. This paper traces its history and finds that the Federal Reserve has been most successful in its dual full-employment, low inflation mandate when it follows fixed rules, and focuses on the intermediate term rather than trying to react to short-term developments under political pressure. Going forward, monetary policy should emphasize on annual monetary growth more and short-term interest rates less. A number of policies are recommended to support this overall emphasis on intermediate-term stability.

Business Economics (2013) 48, 96-103.

doi:10.1057/be.2013.7

Keywords: Federal Reserve, independence, monetary policy, monetary history, Taylor Rule

  I don't suppose that anyone would still argue that the
  central banking system should be independent of the Government
  of the country. The control which such a system exercises over
  the volume and value of money is a right of Government and is
  exercised on behalf of Government, with powers delegated by
  the Government. But there is a distinction between independence
  from Government and independence from political influence in
  a narrower sense. The powers of the central banking system
  should not be a pawn of any group or faction or party, or
  even any particular administration, subject to political
  pressures and its own passing fiscal necessities. [Allan
  Sproul, President of the New York Federal Reserve Bank
  letter to Robert R. Bowie, September 1, 1948 [Meltzer
  2003, p. 738]

Few would disagree with Sproul's statement. The greater problem is not agreeing about the desirability of independence. It is finding institutional arrangements to achieve it and retain it if it is achieved.

We all learned, and many repeat, that the Federal Reserve is independent within government. That was certainly true of the Federal Reserve in 1913, but by 1917 it helped to finance the war by lending to the Treasury to finance bank purchases of war debt at concessional rates. After the war, the Treasury Secretary insisted on holding low interest rates to support refunding of government debt. (1)

The 1920s were better. Secretary of the Treasury, Andrew Mellon, started the decade by letting interest rates rise. Benjamin Strong, the Governor of the Federal Reserve Bank of New York, was the dominant personality strong enough to prevent the Board in Washington from gaining control of policy. However, Strong circumvented the clear prohibition against using monetary policy to finance the Treasury by actively purchasing and selling government securities in the open market. And the Board agreed to modify the prohibition against direct Treasury finance by putting a dollar limit on the amount of direct finance.

One strand of Federal Reserve history develops the shift in power and influence toward Washington. President Wilson's compromise made the Board in Washington an overseer of the semi-independent Reserve Banks. Wilson's compromise settled the issue long enough to get Congress to pass the Federal Reserve Act. The issue of control reemerged almost at once.

Discussion at the time described the Board of Governors as a political body, the regional banks as representing business and possibly consumers. Prohibitions to support independence included the aforementioned prohibition on direct Treasury finances, but also gold standard rules, portfolio decisions controlled by Reserve Bank directors, the real bills doctrine, and 14-year terms for Board members. Real bills restricted Federal Reserve purchases to financing commercial paper and acceptances brought at the option of members to the Reserve Banks. The main discretionary action left the banks free to set their discount rates subject to approval by the Board.

By the 1920s, Governor Strong had organized the banks into the open market committee empowered to decide on purchases and sales in the open market subject to Board oversight and portfolio approval by bank directors. …

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