Interest in the Fed Chair’s succession is now on par with that of the Chief Justice of the U.S. Supreme Court. A public and Congress, capable of consideration of constitutional questions with regard to the Supreme Court, should be capable of considering substantive questions regarding the governance of the independent Federal Reserve. Yet commentary in the media has focused on personality, style, and gender and has been sorely lacking in substantive content.
Senate confirmation of the Chief Justice turns on the Supreme Court’s jurisdiction, and on how much deference the Supreme Court should grant to political institutions. One should view the confirmation process for Fed Chair, in a like manner, 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 operational means 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. The Chair’s succession matters hugely for how the Fed will act in the future.
The primary consideration in appraising the appropriate boundary for the Federal Reserve’s independent operations is the distinction between monetary policy (narrowly defined) and credit policy.
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% inflation target announced by the FOMC in January 2012.
In contrast to monetary policy, Fed credit policy has little effect on the level of market interest rates and inflation. Credit policy involves Fed lending to private entities financed by the sale of Treasuries from the Fed’s portfolio or with freshly created bank reserves. Fed credit policy exploits the government’s creditworthiness—via the sale of Treasury debt from the Fed’s portfolio against future taxes—to finance loans to distressed borrowers. The Fed eventually must drain any reserves created to finance credit policy by selling Treasuries in order to prevent future inflation, or else the Fed will have to pay a market interest rate on the reserves. Either way, Fed credit policy involves the lending of public funds to favored borrowers financed by interest-bearing liabilities issued against future taxes.
In short, Fed credit policy is “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 absence of clear limits on Fed credit policy creates another problem, too, due to the tendency for Fed last resort lending to expand in reach and scope, with increasingly distortionary and destabilizing consequences. For instance, in the 2007-8 credit turmoil the Fed was put in a no-win situation given its wide powers to lend—disappoint expectations of accommodation and risk financial collapse or take on expansive underpriced credit risk, as Paul Volcker put it “with the implied promise of similar actions in times of future turmoil.” The Fed chose the latter course of action—even allowing two major investment banks (not previously regulated or supervised by the Fed) to quickly become bank holding companies so they could access the Fed discount window.
In the 19th century, the Bank of England followed Walter Bagehot’s classic last resort lending advice “to lend freely at a high rate on good collateral.” The Bank of England did not take on credit risk because the Bank was a private, profit-maximizing institution whose shareholders earned the profit and bore the risk of loss.
The Federal Reserve, however, operates under very different incentives. The fiscal authorities receive net Fed income after expenses and taxpayers bear any Fed losses. Hence—because the Fed’s own funds are not at stake—the Fed is inclined to take on underpriced credit risk whenever it worries that not doing so would threaten a financial crisis. Moreover, even when the Fed protects itself by taking good collateral, the Fed harms taxpayers if the entity to which the Fed lends fails with a Fed loan outstanding. In that case, the Fed takes collateral at the expense of taxpayers exposed to losses from backstopping the deposit insurance fund or from other government guarantees. By protecting itself against ex post lending losses, the Fed creates ex ante distortions by potentially delaying the closure of insolvent entities. So Fed credit policy facilitates lending laxity and moral hazard.
In light of the abovementioned realities, the Senate confirmation process should ascertain the nominated Fed Chair’s inclination toward broad or narrow use of the Fed’s operational credit policy independence. Senators could then choose to confirm or not, in part, based on their comfort with the nominee’s inclinations in that regard.
The following five questions would serve well to illuminate the designated Chair’s views. They should be addressed to the nominee with a request for answers in writing for the record. 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 what Federal Reserve “independence” should mean:
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 an explicit inflation target—to facilitate the conduct of monetary policy, and explicit limits 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 credit turmoil.
Which most closely reflects your views? Explain.
2. Do you think Congress should hold the Fed accountable for the 2% inflation target announced by the FOMC in January 2012? Yes or no? Explain.
3. 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 to utilize this distinction for purposes of transparency and accountability in explaining its policy initiatives? Yes or no? Explain.
4. 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?
Which most closely reflects your views? Explain.
5. Do you think the Fed should return to the “Treasuries only” asset acquisition policy it followed prior to the 2007-8 credit turmoil? Yes or no? Explain.
Marvin Goodfriend is a Professor of Economics at Carnegie Mellon University’s Tepper School of Business and a Member of the Shadow Open Market Committee
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