Five Questions for Yellen

Janet Yellen’s confirmation hearing before the Senate Banking Committee on Thursday is as an opportunity to consider the appropriate boundaries for the Federal Reserve’s independent operational policies. The Fed Chair has the decisive say

in whether the Fed will utilize broad or narrow operational means to achieve its objectives. The Chair’s judgment establishes operational boundaries between the Fed and the markets on one hand, and between the Fed and the fiscal authorities (Congress and the Treasury) on the other. Janet Yellen’s likely confirmation matters hugely for how the Fed will act in the future.

A primary consideration of this hearing should be to gain an understanding of Yellen’s views on the appropriate boundaries for Federal Reserve monetary policy (narrowly defined) and the Fed’s credit policies.

Monetary policy (narrowly defined) involves operations that expand or contract bank reserves by Fed purchases or sales of U.S. Treasury securities, respectively. Monetary policy works via the provision of bank reserves and interest on reserves to influence the general level of market interest rates. Monetary policy does not favor one sector of the economy over another; and monetary policy does not involve taking credit risk onto the Fed’s balance sheet. Therefore, monetary policy with a “Treasuries only” asset acquisition policy (followed by the Fed before the recent credit turmoil) is well-suited for delegation by Congress to the independent Fed. All Congress need do (to help anchor inflation expectations) is hold the Fed accountable for the 2 percent longer-run inflation target announced by the FOMC in its January 2012 “Statement on Longer-Run Goals and Monetary Policy Strategy.”

In contrast to monetary policy, Fed credit policy has little effect on the level of market interest rates and inflation. Credit policy involves the lending of public funds to favored borrowers financed by interest-bearing liabilities issued against future taxes. This is a “debt-financed fiscal policy” carried out by the central bank. The Fed returns the interest on its credit assets to the Treasury, but all such assets carry credit risk and involve the Fed in potentially controversial disputes regarding credit allocation. So credit policy is a political, fiscal policy matter. Except for occasional short-term Fed lending to regulated, solvent depositories, on good collateral, the presumption should be that credit policy ought to respect the congressional appropriations process and be handled by Congress and the Treasury and not the independent Fed.

The following five questions would serve well to illuminate Yellen’s views on the Fed’s limitations for both monetary and credit policy. The suggested questions would help focus the debate in the Senate and help to initiate a substantive public consideration of the issues at stake.

1) One hears two competing views on Federal Reserve “independence”--

One view is that Congress should set the Fed’s goals broadly, allow the Fed wide operational powers to intervene in financial markets to achieve those goals, and give the Fed virtual free reign to use its operational powers as the Fed chooses.

A second view is that the independent Fed needs the double discipline of a longer-run inflation target—to facilitate the conduct of monetary policy, and bounds on Fed credit policy—to limit the distortion and destabilization of financial markets due to the inclination of the Fed to provide underpriced credit assistance in times of financial turmoil. 

Which most closely reflects your views?

2) Do you think that Congress in its oversight capacity should help the Fed anchor inflation by holding the Fed accountable for its 2 percent inflation target over the longer run?

3) Do you regard flexibility unconstrained by rules or boundaries as a largely unalloyed benefit of Fed operational independence? Or do you worry that unconstrained discretion creates scope for expectations of future inflation or expectations of future underpriced Fed credit assistance that create problems of their own?

4) One can distinguish between Fed monetary policy (the management of bank reserves via open market operations in Treasuries) and Fed credit policy (lending to particular entities or purchasing non-Treasury securities with proceeds from the Fed sale of Treasuries or with the fresh creation of bank reserves). Do you think the Fed should utilize this distinction for purposes of transparency and accountability in explaining its policy initiatives? 

5) Do you think the Fed should return to the “Treasuries only” asset acquisition policy it followed prior to the 2007-8 credit turmoil? 

Marvin Goodfriend is a Professor at Carnegie Mellon University and a Member of the Shadow Open Market Committee.