Thursday, December 11, 2014

Targeting Federal Reserve’s independence is misguided, part 1

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


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.

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