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Leaning on The Fed

By ·April 13, 2017
Fletcher School, Tufts University

The Issue:

The Federal Reserve walks a tight balance between maintaining low unemployment and preventing the economy from heating up and unleashing inflation. Its decisions impact groups differently: raising interest rates can be painful for borrowers and businesses seeking to invest and expand; lowering them can hurt savers and those who depend on fixed income. The independence of the Federal Reserve helps to ensure that it can make politically difficult decisions that are in the long-run best interest of the economy, just as the independence of the judiciary branch helps ensure adherence to the rule of law, even when those decisions are politically unpopular. But this independence does not make the Federal Reserve immune to threats from the executive branch or Congress.
Vacancies at the Fed's leadership as well as political rhetoric and pending legislation make this a particularly vulnerable time for Fed independence. Political pressure on central banks typically results in worse economic performance.

The Facts:

  • A body of economic research, both theoretical and empirical, shows that economies perform better under central banks that are more independent. To illustrate this, the chart shows the relationship between central bank independence (using a recently developed indicator) and average inflation for 19 countries over the period 1980 to 2000. Among these advanced economies, average inflation is significantly lower in countries with more independent central banks.
  • The Federal Reserve, like many other central banks, is separate from the executive, legislative and judiciary branches of government. The Board of Governors of the Federal Reserve consists of seven members who, along with the President of the Federal Reserve Bank of New York and a rotating set of four other Presidents of the regional Federal Reserve banks, set monetary policy in the Federal Open Market Committee meetings held every six weeks. The members of the Board of Governors, but for the Chair and Vice Chair, serve fourteen-year terms and the term of the Chair begins in the middle of a President’s four-year term, in order to insulate the Chair, the Vice Chair, and the members from political pressure.
  • The Federal Reserve sets interest rate policy and also has a role in regulating and supervising the financial system. Its policy is meant to achieve its dual mandate of price stability and low unemployment. The decisions of the Federal Reserve have an important impact on the economy and, through this channel, the political climate. For this reason, politicians may want to influence the decisions of the Federal Reserve. For example, incumbents would like a stronger economy going into an election. The most famous case of this in the United States is Richard Nixon’s efforts to influence Fed Chairman Arthur Burns to stimulate the economy in order to promote his re-election in 1972. Fed policy was, in fact, stimulative in the pre-election period, only to strongly reverse course afterwards in an effort to stamp out inflationary pressures exacerbated by the stimulus.
  • A combination of factors has brought Fed independence to the forefront. Fed policy was in the spotlight during the heated presidential campaign. Candidate Donald Trump attacked the Federal Reserve and Chairwoman Janet Yellen numerous times during the 2016 campaign, although in a very recent interview he said he would consider reappointing her to another four-year term when her current term expires in 2018. The Senate failed to confirm nominees to the Board of Governors of the Federal Reserve during the past few years, so now there are three vacancies on the seven-member board. On March 28, 2017, the House Committee on Oversight and Government Reform passed a measure to allow a government watchdog agency to monitor monetary policy decisions of the Federal Reserve. This “Audit the Fed” act would make monetary policy decisions subject to Congressional review and, potentially, congressional pressure.
  • There is a debate in economics on whether monetary policy should be conducted based on rules (where the central bank automatically responds in a preset way to economic conditions) or in a more discretionary manner (that allows varied responses to current events). But there is no debate as to the point that policy conducted for political ends, attempting to favor one political party or another, damages the economy. Such a politically-influenced policy would increase uncertainty, cause the economy to go through fits and starts, and in general be destabilizing and corrosive.

What this Means:

William McChesney Martin, Jr., the Chairman of the Federal Reserve from 1951 – 1970, famously quipped that a common role of the Federal Reserve is to take away “the punch bowl …just when the party was really warming up.” Removing the punch bowl may be necessary for the ultimate good of the guests but that does not mean that, at the moment of its removal, it is a popular choice. Past administrations have honored the independence of the Federal Reserve, and have made appointments reflecting the nonpartisan nature of the Board of Governors; for example, President Clinton reappointed Alan Greenspan, and President Obama reappointed Ben Bernanke, both of whom were initially appointed by the preceding Presidents. The terms of Chairwoman Janet Yellen and Vice Chairman Stanley Fischer end next year, and there are currently three vacancies on the Board. If the President politicizes these appointments it could damage the independence of the Federal Reserve and, in so doing, the performance of the United States economy.

Topics:

Federal Reserve Bank / Governance / Monetary Policy
Written by The EconoFact Network. To contact with any questions or comments, please email [email protected].
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