Since the 1930s, the Fed has been one of the most independent central banks in the world. This was not always the case. However, today the Fed’s independence is being challenged as never before with serious implications for the economy going forward.
Starting with the founders, they did not contemplate the United States having a central bank that conducts discretionary monetary policy as is practiced today. Monetary policy, as it was thought of late in the eighteenth century, was assigned in the Constitution to Congress in Article 1, Section 8, Clause 5, which reads Congress has the responsibility:
To coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights and Measures;
The founders recognized the need to assign this important responsibility of government and selected the Congress. They chose Congress not because they believed that Congress was ideally qualified for this task, but because they did not trust assigning this task to the executive. They had observed enough abuse of monetary systems in history by executives (monarchs) and the resulting debasement of the currency (inflation) and the disruption it caused. Giving monetary policy to the legislature was considered to be the safer choice. The power of the sword (executive) was to be separated from the power of the purse (legislature).
At the time of our nation’s founding, we were on a gold (fixed exchange-rate) standard which had certain self-regulating features rendering very little scope for discretionary monetary policy. Stated differently, the rules of the gold standard disciplined the monetary system in the United States. The United States remained on a gold standard in one form or another—with only a few interruptions—until August 1971.
It took a century and a quarter for Congress to establish a central bank in the United States, even though central banks had been around in other parts of the world for some time. The Bank of England, for example, was established in 1694. The original purpose of central banks abroad was to assist the government in financial matters, especially when expenditures soared in times of war. Later, these central banks took on the responsibility of being lenders of last resort (a bank for bankers experiencing stress).
There were two experiments at establishing a bank that would assist the federal government in managing its finances—the Banks of the United States (First and Second)—but in both cases considerable political opposition resulted in lapses of their charters.
In the latter part of the nineteenth century, the United States had a series of severe financial crises (banking panics) that resulted in major recessions. Elsewhere, nations that had central banks serving as lenders of last resort performed better under similar circumstances. As a consequence, a growing consensus developed in the United States on the need for a central bank. However, there were sharp political differences in how the bank should be structured. As a result, it took until 1913 before a legislative agreement could be reached to establish a central bank in the United States. This took the form of the Federal Reserve Act.
The original Federal Reserve was, by design, a fragmented institution. It had thirteen separate units—twelve Reserve Banks and a Board in Washington—each headed by a person with the title Governor. (Other central banks were headed by a single Governor.) The seven-member Board in Washington had the Secretary of the Treasury and Comptroller of the Currency (accountable to the Treasury Secretary) as ex officio members—in other words, two from the executive branch.
The primary responsibilities of the new central bank were to supply a new currency (Federal Reserve notes to replace national bank notes in circulation), meet seasonal demand for credit (that varied with the agricultural cycle), and serve as a lender of last resort. Under the gold standard that prevailed at the time, there was little scope for monetary policy as we think of it today apart from acting to ensure that U.S. dollars could be exchanged for gold at a fixed rate of exchange ($20.67 per ounce).
Under the original structure of the Federal Reserve, the various units in the System were competing for control, and there was little accountability across the System. The flaws in the System were revealed by the stock market crash in 1929 and subsequent banking panics. Congress responded by making major changes to the System in 1935 which placed control and accountability in a revamped Board in Washington and gave the Board considerable independence. Contributing to this independence were fourteen-year terms for Board members (each of the seven Board members were given the title Governor, instead of just one, while the heads of Reserve Banks had their titles changed from Governor to President reflecting the primacy of the Board in Washington). Moreover, Board members could not be dismissed, except for “cause,” which was not defined by statute but was thought to be a very serious offense; no Board member has ever been removed for cause and action to remove a governor had not been given serious consideration until recently.
Playing a key role in the 1935 restructuring was Senator Carter Glass from Virginia. Glass had been Secretary of the Treasury from 1918 to 1920, in the early years of the Fed, and thought that the executive branch (through the Secretary of the Treasury and Comptroller of the Currency) exercised too much control over the System. In the words of Senator Glass, the Fed should be as “independent of the President as the Supreme Court.” Adding to the Fed’s independence has been its being outside the congressional appropriations process, meaning that the Fed does not have to seek congressional approval for funds to meet its expenses (the Fed finances its expenses using earnings from its huge portfolio of assets).
The Fed surrendered its independence during WW II when it agreed to hold down interest rates to assist the Treasury in financing the war effort by holding down outlays on servicing the Treasury’s growing debt. The Treasury insisted that the Fed continue to hold down interest rates long after the war ended. Tensions between the Fed and the Treasury came to a boil in March 1951 when an ”Accord” was reached under which the Fed was freed from pegging interest rates.
Meanwhile, the Employment Act of 1946 specified national macroeconomic goals to be maximum employment, maximum production, and maximum purchasing power (of the dollar). However, the Fed, despite its new-found independence, was constrained in using discretionary monetary policy to achieve these goals by the gold-based fixed exchange rate system that was established at the end of WW II (the so-called Bretton-Woods system).
The period from the 1950s to the end of this exchange-rate regime in 1971 was one of repeated attempts to suppress the discipline imposed by the gold-based, fixed-exchange rate regime (which called for more monetary restraint in the United States) in order to focus monetary policy on higher levels of employment. A byproduct of suppressing this discipline was a buildup of inflationary pressure over the 1960s (stemming from a massive increase in federal outlays to finance a domestic war on poverty and an external war in Southeast Asia coupled with considerable executive pressure on the Fed to hold down interest rates).
Once the fixed exchange-rate system was replaced by a floating dollar in 1971, the restraints under the fixed exchange rate regime were fully removed and the Fed was unfettered in its pursuit of domestic goals. However, the chair at this time, Arthur Burns, acceded to pressure from the executive, Richard Nixon, to hold interest rates down for political purposes. The result was continued rising inflation over the 1970s. Burns and his successor, G. William Miller, made frequent public statements about a commitment to reduce inflation which came to be increasingly ignored by the public. Toward the end of the decade of the 1970s, Congress enacted the Full Employment and Balanced Growth (Humphrey-Hawkins) Act of 1978 that more clearly specified the goals of national economic policy to be maximum employment and stable prices (as well as moderate long-term interest rates)—the so-called dual mandate that continues to this day.
It took the next chair, Paul Volcker, to apply the Fed’s independence in launching an unprecedented effort to get inflation under control in 1979. Volcker’s job of breaking the back of inflation would have been much easier (and less painful for most Americans) if the public believed that he was serious and was going to succeed. However, more than a decade of rising inflation in the midst of such statements by Fed officials had fully eroded the Fed’s credibility. Nonetheless, Volcker persisted—and ultimately succeeded—in lowering inflation and placing it on a downward trajectory—and the economy flourished. The country transitioned from the Great Inflation to the Great Moderation, one of the best periods of macroeconomic performance in the country’s history.
The Sixties, Seventies, and Eighties were also a period when the economics profession came to appreciate the role of expectations in influencing the behavior of the public—consumers, businesses, and participants in financial markets. Much attention came to be focused on the contribution of central bank policy to inflation and to the importance of expectations of inflation—which can affect the actual rate of inflation. The profession also came to understand that sustained high levels of employment and output require that the public expects inflation to be in line with the goal of the central bank. If, for example, the public expects more inflation than what the central bank is trying to achieve, there will be more volatility of employment and output than if expectations of inflation matched the goal of the central bank. Thus, we have come to realize that it is critically important for the public to know the goal of the central bank for inflation and to have confidence that the central bank can and will achieve that goal.
Which brings us to the importance of central bank independence. For the central bank’s goal for inflation to be credible to the public, the public must believe that the central bank is not constrained by political forces in achieving its goal. Being protected from political interference—that is, being independent to pursue the goal—is key to the success of the central bank in achieving its inflation objective as well as sustainable high levels of employment.
A major contribution to verifying this understanding was made by economists Alberto Alesina and Larry Summers in 1993 (“Central Bank Independence and Macroeconomic Performance; Some Comparative Evidence,” Journal of Money, Credit, and Banking, May 1993.) They conducted an international study in which they calibrated the degree of independence for each central bank and compared that with the level and volatility of inflation in each economy over a period of more than three decades. Their findings were very robust and consistent with economic understanding: economies with independent central banks had lower and less volatile inflation which contributed to more stable economies.
Since the publication of the Alesina-Summers paper, central bank independence has come to be international best practice and some major central banks (including the Bank of England) have even been restructured to give the central bank greater independence to achieve domestic goals. (Central bank independence usually means that the central bank has independence in pursuing the goals established by elected political leaders—such as price stability.) One can surmise that this finding reflects the ability of independent central banks to resist political pressures from executives to hold down interest rates.
The Fed has for some time understood that its independence in the pursuit of public policy goals renders it to be unique among economic policymaking bodies in the United States. Fed Chair Ben Bernanke, for example, elaborated on the Fed’s unique authority as unelected public officials and the corresponding need for the Fed to preserve its independence by being accountable for its actions and by being transparent (see, Bernanke, Central Bank Independence, Transparency, and Accountability, Board of Governors of the F.R. System, May 25, 2010). Not much later—in 2012—the Fed began to announce a numerical goal for inflation of 2 percent to provide more clarity for economic decision making by the public.
That brings us to the current situation facing the Fed. The Fed’s independence has never been under the kind of attack that it has over the past year. The president has attempted to fire Governor Cook over falsifying information on mortgage applications. Whether this offense rises to being cause for her dismissal is now before the Supreme Court. (There is also the more recent issue of whether Chair Powell’s testimony before Congress on renovations to Board buildings constitutes perjury and rises to being cause for his dismissal.) The Court’s decision on the Cook matter has profound implications for the Fed’s independence and its ability to once again feel little constrained in pursuing the macroeconomic goals set by Congress. The decision also has major implications for inflation expectations and whether the public will come to expect that a loss of Fed independence means that we are returning to the decade of the 1970s with the result being substantially more disruptions to the economy, including to employment and output.
We are living in very interesting times!
Header image: Joshua Woroniecki / Unsplash
Thomas D. Simpson, PH.D. 