What to do about the Federal Reserve

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The short answer is: not much. Hippocrates offered good advice when he said “first do no harm.”

This does not mean that the Federal Reserve is perfect. Parts of its governance structure read like they date from 1913 (as they do) and could use a tune-up. But by and large, the Fed continues to perform the functions assigned to it by Congress well—even in this time of dysfunctional government—and to be genuinely non-political (see below). The next president should not upset either of these apple carts.

Federal Reserve independence

Four points are important to understanding the independence of the Fed. All should be preserved.

1. Federal Reserve independence is limited to monetary policy. The Fed is engaged in other functions, such as financial regulation and supervision, where it generally shares responsibility with other agencies. In those other domains, the Fed has relatively little ability to take unilateral action, that is, little independence. Preserving the Fed’s independence in monetary policy is extremely important to the nation’s economic health and does not require independence in other domains.
2. Federal Reserve independence is not absolute, even in monetary policy. In fact, it’s based more on tradition than law. Congress can abolish Federal Reserve independence (or the Federal Reserve itself) any day it chooses if the President would sign the bill. That creates a certain fragility and causes angst at the Fed whenever Congress considers ideas that would encroach on its independence. The new President should vigorously support Federal Reserve independence as it exists today. Writing it into law would be even better, if possible. But it probably isn’t, so I wouldn’t advise expending much political capital on this.
3. The President, with the consent of the Senate, appoints the Board of Governors of the Fed, most notably its Chair. This appointment power is an important—probably the most important—element of political influence on monetary policy. And it’s entirely legitimate, even necessary; the Fed should not be a self-perpetuating oligarchy. The appointment of a new (or the same) Fed chair in early 2018 will be among the most important appointments the new President ever makes. It merits serious consideration early in the administration, and should be resolved by late summer or early fall 2017, lest it become a source of market jitters.
4. While appointments to the Federal Reserve Board are “political” in the literal sense, the appointees themselves have generally not been very “political” people (with a few notable/notorious exceptions). Janet Yellen, a Democrat appointed by Barack Obama, is a non-political technocrat. Prior to that, President Obama had reappointed Ben Bernanke, another non-political technocrat, even though he was a Republican originally appointed by George W. Bush. That non-partisan tradition goes back a long way ( Ronald Reagan reappointed Paul Volcker, a Democrat.) We do not want to turn top Fed appointments into partisan political donnybrooks like Supreme Court appointments. Sadly, Senate Republicans have started down that path in recent years by blocking or refusing to consider appointments to the Federal Reserve Board. That tendency should be fought.

Troublesome bills
now in Congress

I started with “first do no harm” because Congress is now considering three very bad ideas.

1. Audit the Fed: H.R. 24 and S. 2232 are two versions of what used to be called “Audit the Fed.” A more accurate name would be “Institutionalize Browbeating of the Fed.” The Federal Reserve’s books are already audited, and have been for years. This bill would give Congress (using/abusing the Government Accountability Office as a vehicle) more ways to second-guess the Fed’s monetary policy decisions. Individual members of Congress can, of course, do that whenever they please—and some do. Why would anyone want to give Fed-bashing institutional stature and legitimacy? The answer is obvious: to intimidate the Fed.
2. Form Act: Formerly the FRAT Act, H.R. 3189, which includes “Audit the Fed,” would also add a requirement that the Fed enunciate-and explain why it ever deviates from-a mechanical formula for monetary policy. (There are counterpart bills in the Senate.) There is a long academic debate over “rules versus discretion,” but that debate preceded the unprecedented circumstances the Fed has faced since 2008. It is frightening to contemplate what might have happened if the Fed had followed a pre-2007 rule under those never-before-imagined circumstances. Legislating compliance with a rule now seems both dangerous and irresponsible.
3. Congressman Hensarling’s proposed replacement for Dodd-Frank. Proposed legislation by Rep Jeb Hensarling (R-TX) has many bad features, one of which would subject the Fed’s budget to annual congressional appropriations. Freedom from annual appropriations is perhaps the lynchpin of the Federal Reserve’s independence. No central bank can be independent if a displeased legislature can squeeze its budget as Congress routinely does with other regulatory agencies.

The new President should oppose these three anti-Fed bills, and veto them if Congress passes any of them.

What (that’s sensible)
might be changed?

According to a wise old principle, if it ain’t broke, don’t fix it. The Fed is not “broke.” So preserving the status quo is not a bad policy.

It is true that, were the Federal Reserve Act being written today rather than in 1913, it would look different in several respects. For instance, the boundaries of the 12 Federal Reserve Districts and the locations of the 12 Federal Reserve Banks would certainly be different. Those boundaries, which reflect the economic geography and political logrolling of 1913, look a little comical in 2016. But moving them is almost certainly not worth the political fight it would provoke.

A better case can be made for revisiting the 1913 Wilsonian compromise between two competing visions of a central bank: one controlled by private parties (mainly bankers), the other controlled by the federal government. The Federal Reserve Act (and its 1935 amendments) split the difference by dividing power between a seven-member, politically appointed Board of Governors in Washington and 12 Federal Reserve Banks, which are joint-stock companies owned by member banks, and whose presidents are not political appointees. (They are, instead, selected by each bank’s board, just as private corporations do.) The Fed’s powerful Open Market Committee consists of the seven Washington-based governors and the 12 bank presidents (only five of whom get to vote at a time). It is odd, to put it mildly, to have men and women with no political legitimacy making national economic policy.

In increasing order of “radicalness,” the Wilsonian balance could be tilted more in the governmental direction by:

1. Removing all bankers from the boards of the Reserve Banks (doing so, however, would create an odd legal situation since the private banks are the Reserve Banks’ shareholders.)
2. Making the President of the Federal Reserve Bank of New York, which has a special status within the Federal Reserve System, a presidential appointee confirmed by the Senate, just like the Board of Governors
3. Making all 12 Federal Reserve Bank presidents political appointees, appointed either by the president or by the Board of Governors
4. Converting all the Federal Reserve banks into government agencies, with their presidents appointed by either the Board of Governors or the President

Another sensible reform would be to shorten existing term limits. Under current law, a Federal Reserve governor (including the chairman) could, in principle, serve almost 28 years. Although this has never happened, Alan Greenspan did chair the Fed for 18½ years, and William McChesney Martin served a few months longer than that. For such a powerful position, that seems too long. When he retired in 2014, Ben Bernanke did not try to set a “George Washington” precedent that two four-year terms is enough. Perhaps we should write that into law.

What about the next recession?

Should the U.S. economy encounter a recession any time soon—say, within the next two years—the old “leave-it-to-the-Fed” attitude will probably not suffice. For one thing, interest rates will still be very low, leaving the Fed limited scope for cutting rates. For another, the Fed’s balance sheet will still be huge, leaving it limited scope for further “quantitative easing”—not to mention the fact that quantitative easing probably ran into sharply diminishing returns years ago. All this is not to say that the Fed would be powerless to fight, say, a 2017 recession, but only that it will be considerably less powerful than it has been in the past, leaving the nation more vulnerable.

What to do? The obvious answer would be to deploy fiscal policy—that is, government spending and tax cuts—as was done in 2009. But, depending on the composition and attitudes of the next Congress, that might prove challenging (or impossible) politically.

So the first, and easy, policy recommendation is that the new administration should quickly formulate contingency plans for a possible fiscal stimulus and, to the maximum extent possible, seek buy-in from the congressional leadership.

That “maximum extent possible” might prove to be zero, however. So the new administration should also consider legislation that would increase the strength of the automatic stabilizers.

1. Any increases in marginal tax rates, or in the marginal generosity of transfer payments such as unemployment benefits and food stamps, will have this effect as a by-product. If marginal tax rates were higher, however, tax bills would fall faster when incomes declined.
2. In addition, the new administration should consider legislation that raises unemployment benefits and food stamps formulaically and automatically when the economy crosses certain (adverse) thresholds—when the unemployment rate rises above 6 percent, 7 percent, and so on. President Obama made such a proposal for unemployment benefits this year.