Targeting Federal Reserve’s independence is misguided, part 2

Published in Standard-Examiner, November 16, 2014, Ogden, Utah

VIJAY K. MATHUR

In part 1 of my column I discussed the Federal Reserve’s (Fed) structure, its responsibilities and implementation of monetary policy, independent of political interference. Here, I discuss different views (of Monetarist and Keynesian schools) on the conduct of monetary policy and the issue of the Fed’s independence from political pressures.

First some background. One of the conclusions arrived at by Professor Ben Bernanke, former Fed chairman, in his path-breaking book “The Great Depression,” is that in all countries monetary contraction was the major cause of the Great Depression of the 1930s. Even with widespread bank panics, sharp price decreases, and output and employment contraction, monetary policy was circumscribed by the prevailing gold standard. Countries that abandoned the gold standard had greater flexibility in initiating expansionary monetary policy (U.S. after 1933) to provide liquidity to banks and stabilize prices, hence output and employment. Bank panics significantly affected supply of output.

Congress created an independent Fed in 1913 to avoid financial panics before World War I. The Fed faced the most severe test in the Great Depression. Some conservative politicians and economists have questioned the Fed’s independence and its discretionary monetary policy.

Nobel Laureate conservative economist Milton Friedman (now deceased), leader of the Monetarist school, argued that discretionary monetary policy could be destabilizing to the economy in the short run. This could happen due to time lags in gathering information and uncertainty about the monetary policy’s effect on the economy. In the long run, monetary policy could be more effective in stabilizing prices. Friedman argued that a rule-based policy, such as a target rate of growth in money supply, is more credible and creates more certainty in markets, thus creating price stability in the long run and encouraging firms to increase output and employment. It is ironic that Friedman was fearful of political pressures on the Fed on its decisions.

Perhaps those politicians who wish to have more control over monetary policy do not like the discretionary nature of the Fed’s policies pursued in the Great Recession of 2007-2009 or their quest for control may be guided by Friedman’s views on monetary policy.

An activist monetary policy for the short run is the Taylor Rule, proposed by Stanford University Professor John Taylor. Andrew Abel, Ben Bernanke and Dean Croushore argue that the Taylor Rule establishes interest rate, rather than money supply, as an intermediate target of monetary policy to provide economic stimulus.

The rule states that the inflation-adjusted federal funds rate (real interest rate) responds to the difference between actual output and full-employment output and the difference between the actual inflation rate and the target inflation (considered to be 2 percent) rate. Therefore, if the economy is at full employment output and actual inflation rate is 2 percent the Fed should set the real interest rate at 2 percent. It should decrease the real interest rate below 2 percent if the economy is weak and increase it above 2 percent if the economy is overheating.

Keynesians recommend a flexible and activist monetary policy, depending upon the state of the economy. Monetary policy could be effectively used not only to stabilize prices but also to promote growth and employment. The Fed followed the Taylor Rule as a guide to achieve its goals in the short run. To make the economy grow in the long run it followed quantitative easing (QE). QE provides liquidity by buying assets such as government securities (Treasuries) and private sector securities. The Fed recently ended QE due to a pick up in economic growth; however, it would keep short-term interest rates very low for the near future.

Total attention of many conservatives to inflation rate is unwarranted. The Federal Reserve Bank Act of 1978 requires the goal of full employment. Despite the limited role played by tax and expenditure policies to combat the recent Great Recession, monetary policy had been very effective in boosting employment and growth, and in controlling the inflation rate.

The inflation rate now is hovering around the target of 2 percent. The current unemployment rate of 5.9 percent is close to full employment unemployment rate, and the U.S. is the only advanced country experiencing potential economic growth of 3.5 percent. Had Congress enacted robust tax and expenditure policies, the unemployment rate and growth would have been even better. Congress even ignored the advice of Professor Bernanke as Fed chair, on fiscal policy in his 2013 testimony in the Senate committee. Political debates and dysfunction in Congress undermined prospects for timely action on fiscal policy. Control of Fed’s monetary policy by politicians, feared by Professor Milton Friedman, will not establish the Fed’s credibility.

The study of 16 advanced countries by Professors Alberto Alesiena and Lawrence Summers found lower average inflation rates in countries with greater independence of central banks. Effectiveness of monetary policy would be compromised with more political intervention and supervision than what we have now.

Congress would be more productive if it settles on certain principles of its own to guide debt, tax and expenditure decisions in a timely manner to deal with recessions and inflation episodes, rather than being mired in endless political debates and indecisions.

Mathur is former chairman and professor of economics and now professor emeritus, Department of Economics, Cleveland State University, Cleveland, Ohio. He also writes online for this paper. He lives in Ogden. Part one of this two-part series was in the Nov. 9 Standard-Examiner.

Targeting Federal Reserve’s independence is misguided, part 1

Published in Standard-Examiner, November 9, 2014, Ogden, Utah

VIJAY K. MATHUR

The Federal Reserve System (Fed) played a major role in averting depression in 2007-08. Historically, rigidity in monetary policy was one of the main causes of the Great Depression of the 1930s. However, it is alarming that many media pundits, politicians and Americans lack even rudimentary understanding of this institution and its role in stabilizing prices and the economy.

Many Republicans and some Democrats in Congress are calling for more transparency and congressional control over the Fed. Former Congressman Ron Paul even wants to eliminate it. Most are unaware of the fact that the Fed is already subject to congressional oversight. There are audits by the GAO, external audits and regular congressional hearings on Fed’s policies. It appears that politicians who disagree with the monetary policy want more control. This should concern all Americans.

It would be a travesty if monetary policy were conducted in the political theater. In this column I attempt to familiarize readers with the Fed and its role in the conduct of monetary policy, while in part 2 I will discuss different views on the conduct of monetary policy. Monetary policy requires deliberate flexible and timely strategies and actions to deal with recession and inflation episodes. Had monetary policy been subjected to political debates and media hysteria in 2007-08, we would have had a financial panic here and abroad and perhaps worldwide depression.

To avoid bank panics like those in the 19th century and early 20th century, Congress passed the Federal Reserve Act in 1913 to create the Fed. The Fed is the bank for banks and not the bank for individuals and businesses. A Board of Governors provides the leadership, and the president appoints its chairperson and six other members. Currently, economist Janet Yellen holds that position. There are 12 regional Federal Reserve Banks (Fed banks) with boards of directors, in 12 districts, to provide services to members of the Fed in their districts and carry out policies. Utah’s banks are in the 12th District, under the supervision of the Federal Reserve Bank in San Francisco. Member banks in the district are owners of the district Fed bank. The Federal open market committee (FOMC) is the main policy making body.

The Fed’s goals are price and financial stability, low unemployment rates and economic growth. Monetary policy deals with decisions on money supply (quantitative easing is an extension of this policy) and interest rates. Among many different measures, M1 is the simplest measure of money supply. M1 consists of currency in circulation held by non-bank public and deposits in checking accounts of banks (demand deposits). Fed does not print money to change the money supply, as some media pundits and politicians believe. As shown later, it can change M1 by affecting demand deposits of depository institutions.

The Fed supervises and regulates domestic and foreign banking institutions, and other large complex financial firms. Fed banks provide services such as check clearing, wire transfers and electronic payments to depository institutions. Fed banks also hold members’ reserve accounts, lend money to members and distribute currency to meet public demand.

Fed banks are not profit-making banks, as some believe. However, they do provide services to the U.S. Treasury, and other U.S. government and international agencies. They receive deposits of the U.S. Treasury for items like federal unemployment taxes, income taxes, corporate taxes, payroll taxes and certain excise taxes. They earn their income from interest on government securities, which they hold in the conduct of monetary policy, and fees for services to depository institutions. Excess of annual earnings over expenses of the Fed are returned to the Treasury.

Three main tools of the Fed to change money supply and interest rates are 1) required reserve to deposit ratio (RR), 2) discount rate (interest rate on loans to depository institutions) and 3) open market operations by FOMC (buying and selling of securities, such as Treasury securities, Government bonds and mortgage-backed securities). Increasing (decreasing) RR, increases (decreases) banks’ reserves with the Fed, leads to less (more) lending by banks, hence less (more) demand deposit creation, and therefore less (more) money supply. Increasing (decreasing) discounts rate incentivizes banks to borrow less (more) from the Fed and lend less (more), thereby contracting (expanding) money supply.

The open-market operation is the most effective tool of FOMC. Since most people and institutions, domestic and foreign, hold securities in their asset portfolios, selling (buying) securities at attractive prices decreases (increases) money supply in the economy. All the tools affect banks’ reserves at the Fed and hence money supply. Banks’ reserves also affect the federal funds rate (short-term interest rate) banks charge on mostly overnight loans to other banks that need funds, thus affecting other short-term interest rates in the market.

Economists Andrew Abel, Ben Bernanke and Dean Croushore state that money supply affects economy through changes in interest rates, foreign exchange rate and perhaps supply and demand of credit. The economic effectiveness of monetary policy through these channels requires an independent Fed, free of political pressures.

Mathur is former chair and professor of economics and now professor emeritus, Economics Department, Cleveland State University, Cleveland, Ohio. He also writes online for this paper. He lives in Ogden.