Has the Fed Compromised Its Independence? (And Otherwise Messed Up?)

Today in the Financial Times, John Plender has an apple pie and motherhood column on the importance of central bank independence, It’s a tad ironic, since he fails to recognize that it’s an illusion in the US. But Plender isn’t to be faulted. An entire generation has grown up in the Greenspan/Bernanke era, and thus has no idea of what an independent central bank in the US would look like. As the article demonstrates, Plender’s view is widely shared:

There are few things on which economists are in total agreement. But practitioners of the dismal science come pretty close on the issue of independent central banking. Most see the move to hand operational control of monetary policy to central banking technocrats as having provided vital underpinning for the recent long period of low inflation and stable growth. Yet the independence of the world’s leading central banks is increasingly under threat…

As yet, the US Federal Reserve’s position looks less vulnerable. But Paul McCulley of Pimco, the bond fund manager, believes that the game has changed since the Bear Stearns rescue. This, he argues, was a fiscal policy action little different from the role of Congress in bailing out Chrysler. Having watched the Fed conduct a multibillion-dollar bail-out of an investment bank that it did not supervise, the politicians may now apply pressure for the central bank to firefight elsewhere.

That is not to say the Fed’s operational independence in setting interest rates will be impaired. Mr McCulley’s point is rather that the Fed will be less independent in regulatory matters, as well in as the size and composition of its balance sheet.

The biggest threat to independence, though, could simply come from a failure to keep the lid on inflation. There are signs on both sides of the Atlantic that monetary policymakers have been slow to recognise the extent of the current inflationary threat.

Former Federal Reserve economist Richard Alford takes issue with that view. Alford has criticized the Fed’s recent policies (see here for an interview that was very popular with readers) and has gone digging deeper to find its roots.

Alford was so kind as to share with me an article he is developing. It’s a bit too long to post in full, so let me give the broad strokes followed by the concluding section.

Few have any memory of America’s central bank having a openly contentious relationship with the Treasury and Congress. Even though Paul Volcker had to withstand considerable pressure, some of his predecessors fought open turf wars. Yet from the end of World War II to the (sadly) supine Arthur Burns era, there were not infrequent pitched battles with the Fed with incidents that would seem unthinkable now. For example, Truman summoned the FOMC to pressure them into a more accommodative policy during the Korean War, then issued a White House press release claiming the Fed had made a commitment that it had not agreed to. The Fed played hardball, leaking its version of the meeting, which contradicted the press release. That led Congress to join the fray, trying to bring the Fed to heel via sharply critical hearings.

While Volker did endure widespread criticism and harangues from Congress, even for those who lived through that era. the memories of the ritual roughings up are dim. In addition, there was at least initial support for his harsh measures. Moreover, (unbeknownst to me) Volcker was masterful at defanging Congress long enough for his remedies to take hold. Had someone less adept been at the helm, a firefight might well have ensued.

I do hope Alford’s thesis reaches a broader audience. From Alford:

This most recent period is the trickiest to come to grips with. There has been no sustained acceleration in the rate of inflation. The FOMC wasn’t called to the White House. No Chairman was denied reappointment. The semi-annual Congressional kerfuffle over monetary policy became a tea party.

However, there are reasons to look beneath the tranquil surface. Inflation in the latter part of the period was by one estimate 50-100 basis points lower than it would have been had it not been for globalization and imported disinflation. Furthermore, while measured inflation remained low and relatively stable, there were two significant asset bubbles, the trade deficit reached 6% of GDP, and the personal saving rate fell to 0.0%. Hence the question remains — did the Fed promote short-term gains and high employment with low inflation, at the expense of long-term problems engendering unsustainable financial and external imbalances?

With respect to the housing bubble, the Fed asserts its innocence. It says that monetary policy was appropriate. It also takes the position that while, ex post, it is clear that supervision and regulation was too lax, no one saw the housing and credit bubble forming. Consequently, they cannot be blamed. There are problems with these defenses.

The assertion that the stance of monetary policy was appropriate given the measured inflation rate just assumes away the problem. If policy contributed to the bubble, then it was inappropriate regardless of the inflation rate. Contrary to the Fed position, people did see the housing and credit bubbles forming, although they were in the minority. Most importantly, the Fed as the central bank and the principle banking regulator alone had the responsibility of forestalling systemic risks. Even if no one else saw the bubble forming, the Fed should have. Saying no one else saw the crisis brewing is no defense.

Since the first Latin American debt crisis, we have had a Fed that has been eager to lean against financial headwinds, but completely unwilling to take in sail when dealing with strong financial tail winds. The Fed did not the lean against either the NASDAQ or housing bubbles. Greenspan acknowledged that the NASDAQ might be a bubble, but decided it was appropriate to wait until the bubble popped and then mop up. Post 2000, the Fed denied the existence of a housing bubble. It ignored the declining credit standards, increased leverage, declining quality spreads and a Fed funds target below that implied by the Taylor Rule. The Fed then chose to characterize the bubble as localized froth even after it started to deflate. It then asserted that it was a contained sub-prime problem.

We have a Fed that is willing to incur short-term costs if it reduces inflation, but will not incur short-term costs to achieve financial stability or external balance. This would be less of a problem if another agency or agencies had the willingness and ability to insure financial and external balance, but it is clear that we do not. The Fed was granted independence and insulated from political pressure in order to accept short-term costs in order to enhance the prospects for long term growth. However, the current Fed, like the Fed of the 1970s, failed to use the freedom it was granted.

Assuming for the moment that the Fed either made an error of commission (spiking the punch bowl) or omission (failure to exercise its regulatory and supervisory powers), is there any reason to believe it was the result of an erosion of the independence of the Fed? Unfortunately, the public record suggests that Fed independence has been compromised. There is reason to believe that Greenspan entered into deals with two of the three administrations during his tenure as Chairman. Some commentators believe that he entered into deals with all three. However, the number is unimportant. What is important is that the Fed’s independence was compromised and a very public precedent was set. Never again will an FOMC Chairman be able to say “The Fed does not make deals” to a President or a Secretary of the Treasury or a member of Congress.

Compare the behavior of the Chairmen of the 1950s and Volcker to that of Greenspan. Chairman Eccles and McCabe both lost their Chairmanships because they wouldn’t compromise Fed independence. They stood their ground even after being summoned to the White House. Martin, appointed by Truman, was in later life referred to by Truman as “the traitor” presumably for taking the punch bowl away. The public image of Volcker is that of a man who twice a year endured public Congressional assaults, resisted political pressure, and enabled the Fed to stay the course.

Greenspan, on the other hand, jumped at the chance to meet Clinton, traveling to Little Rock before the inauguration. Bob Woodward in his book “Maestro” quotes Clinton telling Gore after the pre-inauguration meeting: “We can do business.” Woodward also quotes Secretary of the Treasury Bentsen telling Clinton that they had effectively reached a “gentleman’s agreement” with Greenspan. The agreement evidently involved Greenspan’s support for budget deficit reduction financed in part by tax increases. It is not clear what Greenspan received.

Even if the deal with Clinton contributed to a good policy mix, Greenspan should never have entered into that agreement/deal/understanding or another agreement/deal/understanding. The very act of negotiating and injecting the Fed into a discussion of budget decisions compromised Fed independence. Why shouldn’t Bush have expected the same? Why shouldn’t every succeeding President expect the Fed Chairman to be a “business” partner? Refusal to deal on the part of the Fed can no longer be attributed to principle and precedent. Refusal “ to do business” will now be viewed as a rejection, partisan or otherwise. The Fed is no longer able to stand apart from political battles. Greenspan severely compromised the Fed standing as an agency insulated from the short-sighted and partisan politics of Washington DC.

Greenspan risked the NASDAQ bubble during the Clinton years (part of the quo for the quid?) and more recently implicitly accepted the risk of a housing bubble as he touted ARMs as the Bush Administration and Congress promoted the ownership society. Financial innovation was lauded while it produced short-term gains. The Fed failed to adequately pursue its regulatory responsibilities as it kept rates low, despite the relatively high levels of leverage, derivatives markets that dwarfed the underlying cash markets, breakdowns in lending standards and credit spreads that even it didn’t think compensated for the risks. Like Greenspan, the current Fed implicitly decided to risk long term stability rather than incur short-term costs. With globalization holding down measured inflation, it seems that no risk was not worth taking.

After failing to use the independence granted to it by statute, the Fed is now pushing the bounds of its legal authority. It is making decisions that might better be reserved for elected officials. It argues that these steps are necessary, but the Fed is being drawn into the micro management of credit allocation and income re-distribution — a far cry from “inflation targeting”. The Fed is willingly injecting itself into areas that are the provenance of the Congress. Congress has not objected yet, but it will when it is to Congress’s advantage. Will it have costs? How does monetary policy designed by the people responsible for the tax code, fiscal deficit and Federal debt sound?

Greenspan had very considerable political skills, but he did not use them to maintain Fed independence or insulate the Fed as it took policy steps that imposed short-term costs. He curried political favor and opined on issues other than monetary policy. There is no evidence that Bernanke made a deal. Bernanke also made it clear that unlike Greenspan he would refrain from commenting on issues other than monetary policy, but there is evidence that it was too late and that the Fed is “in play”. Recent behavior, first by the Administration and now by the Senate, indicates that positions on the Board of Governors are to be treated as patronage jobs doled out to party loyalists. The qualifications of a recent appointment look to be entirely political. Dodd’s refusal to consider confirming any appointments until after the next election is just as egregious, especially when one considers the depleted Board, soon to be down to three (2 if one assumes that Bernanke will retire when he isn’t reappointed Chairman.), and the challenges facing the Fed.

I am reminded of a Thomas Nast political cartoon from the 1870s. It features a banner across the Capitol building that reads:
“To the victors belong the spoils. We must spoil everything.”