Monetary policymakers always face tradeoffs, and today provides no exception. By holding interest rates lower, for longer, Federal Reserve officials might temporarily strengthen the economy, but only at the cost of risking higher inflation down the road.
To help manage these tradeoffs between short-run gains and long-run costs, the Federal Reserve, like many other central banks, has been granted considerable independence. Fed Governors are appointed by the U.S. President and confirmed by the Senate, but enjoy lengthy 14-year terms. Federal Reserve Bank Presidents are further removed from the political process: They are appointed by their Boards of Directors, subject to the Governors’ approval. The Governors and Bank Presidents make their policy decisions at Federal Open Market Committee meetings that are free from the direct influence of elected government officials.
How can an independent Federal Reserve remain accountable to the American people? To answer this question, it suffices to note that the U.S. Congress has always specified the overriding goals for monetary policy. A 1977 Amendment to the Federal Reserve Act, for example, is the source of the current “dual mandate,” asking the Fed to keep inflation low while also maximizing employment. Periodic hearings, such as those held last week, at which the Federal Reserve Chair reports to Congress help insure that the Fed uses its independence properly, to achieve its legislatively mandated goals.
Guy Debelle and Stanley Fischer’s 1994 Federal Reserve conference paper recasts the distinction between independence and accountability as one between “instrument” and “goal” independence. The Fed enjoys full instrument independence, since it freely designs the procedures through which it achieves its goals. But the Fed has little goal independence, since Congress determines its mandate.
Debelle and Fischer argue, in fact, that the Fed might benefit from having even less goal independence than it does today. Because the statutory dual mandate fails to prescribe a specific target for inflation and because it fails to indicate whether price or employment stability ought to be the principal goal of monetary policy, considerable ambiguity remains as to exactly what Congress wants the Fed to achieve. Similar points are made by Ben Bernanke, Thomas Laubach, Frederic Mishkin, and Adam Posen in their 1999 volume on Inflation Targeting, which presents evidence that U.S. monetary policy could be improved under a revised mandate that recognizes that by stabilizing inflation first, the Fed creates circumstances most favorable for employment growth as well. The fact that the authors of these two studies include current and former high-ranking Fed officials makes their calls for a sharper and more explicit mandate even more compelling.
To bridge the gap between independence and accountability, the Fed could become more transparent by referring publicly to a monetary policy rule that links its operational setting for the federal funds rate to the final goals prescribed by Congress. The rule formulated by John Taylor in 1993 does this, by specifying how the funds rate can be adjusted in response to changes in both inflation and output so as to achieve both sides of the Fed’s dual mandate. Importantly, Taylor proposed his rule not as a prescription for how the Fed should behave but as a description of how the Fed did behave from 1987 through 1992, a period during which its policies were generally regarded as sensible and appropriate. In the same spirit, the graph below compares settings for the funds rate dictated by the Taylor Rule to the actual values for the funds rate since 2006.
The graph confirms that the Fed followed the Taylor Rule almost exactly as the economy began to weaken in 2007 and the downturn intensified in 2008. The Fed could use a graph like this to reassure observers that its recent policy decisions remain consistent with its long-standing goals.
The graph also reinforces another point made by Taylor, which is that a simple rule serves only as a guide and need not be followed blindly or mechanically. The Fed has held the funds rate down since mid-2010, even as the Taylor Rule has called for higher rates, to make up for the earlier period when the zero lower bound prevented policy from easing as much as the Rule required.
By using a rule as a benchmark rather than a mechanical procedure, accountability only implies that it would be incumbent on the Chair to explain to Congress why the Fed decided to deviate from the rule’s implied values. Rather than the acrimony that marred last week’s hearings, everyone’s attention would focus instead on the relevant question: Has enough stimulus already been applied, through years of exceptionally low interest rates, to bring inflation back to the Fed’s two percent target?
Michael Belongia is a professor of economics at the University of Mississippi. Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market Committee.
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