Less or more independence: What does the US Federal Reserve need?

Can the US Federal Reserve continue to remain independent while making policy, going forward? Or should it become more politically accountable?

That is the subject of a new paper by the Brookings Institution titled “Federal Reserve Independence in the Aftermath of the Financial Crisis” by Donald Kohh, a former Federal Reserve Vice Chairman. 

What is the background for the paper?

During the course of the recent global financial crisis, the Federal Reserve, along with other central banks around the world, took some extraordinary measures to ensure the crisis did not lead to a devastating collapse of the global economy.

While the Great Depression 2.0 might have been averted, the Fed hasn’t been terribly successful at reviving the US economy.

That has engendered a fair amount of discontent among American politicians and ordinary people about whether the Fed is doing the right things for the economy, even as a lingering perception persists that the central bank, at the height of the credit crisis, favoured Wall Street over Main Street.

Public confidence has also been whittling away in the financial institution in the aftermath of the financial crisis. (Read “Do Americans have faith in Federal Reserve chief Ben Bernanke?”)

Not surprisingly, some quarters have been calling for clipping the independence of the Fed, or at least making it more accountable for its actions to elected officials.

So should the Federal Reserve be less independent?

Kohn, expectedly, argues that less independence is NOT a good thing for the central bank.

“We should be concerned about the potential for reduced independence: evidence over time and across countries indicates that less independence is correlated with higher inflation,” notes Kohn in the paper.

“The wisdom of a high degree of independence for central banks in the conduct of monetary policy is well established. Independence is critical in the setting of the instruments—interest rates and the like—to achieve these goals,” he argues.

“Central banks should be held ultimately accountable for outcomes, and not for the techniques they used to get to those outcomes.

“Instrument independence is necessary to overcome the short-term perspective of politicians, who tend to be more interested in boosting economic growth before the next election and less focused on the longer-term inflationary consequences of such actions.

“This view is widely shared around the globe as evidenced by the lengthening lists of central banks that are, in this sense, independent of the elected government.”

What are the main threats that undermine Fed independence?

In his paper, Kohn lists four key risks:

One, an era of polarised political views isn’t exactly helping create an atmosphere that is conducive to a reasonable discussion of the conduct of monetary policy.

Two, some of the Fed’s powers have already been eroded by the Dodd-Frank regulation.

Three, challenges to the Fed’s independence are likely to become more pronounced whe the Fed starts to tighten its super-loose monetary policy.

”At some point the Federal Reserve will need to tighten policy to keep inflation from rising persistently above its 2 percent inflation target. It will need to raise rates and begin returning its portfolio toward its prior plain-vanilla size and composition.

“The decision to turn toward tightening is always difficult and subject to second-guessing in the political sphere,” says Kohn.

Four, the additional responsibility of macro-prudential regulation handed to the Fed will require tighter monitoring — and regulation — of financial institutions, in particular, those deemed systemically important.

But the Fed’s attempts to introduce such regulation could run into considerable political hurdles, which could increase calls to clip the Fed’s wings.

“In the years leading up to the crisis we saw considerable political resistance to even mild forms of tighter supervisory policy, for example, with respect to commercial real estate lending.

“The risk is that greater scrutiny and criticism of this aspect of Federal Reserve activity could spill over to monetary policy. It is important to retain the bifurcation — the differences in governance and accountability for regulation and monetary policy.”

Kohn concludes: “Preserving the Federal Reserve’s monetary policy independence will be critical over the next few years.”

Why?  “There’s just too much history that shows that less independence leads to higher inflation over time.”

To read the paper in its entirety, click here.

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