A History of the Federal Reserve, Volume 2 (5 page)

Informal restrictions on independence vary. Members of Congress and of the administration urge the Federal Reserve to adopt policies that they favor. One example repeated in 1968, in 1982, in 1991, and at other times is pressure to reduce interest rates when Congress approves a tax increase. In 1968 and 1982 the Federal Reserve responded to this pressure. In 1991, following the Bush tax increase, the FOMC reduced rates to spur the economy.

One manifestation of independence is budgetary authority. The government budget reports the System’s spending as an appendix and records a transfer of 90 percent of Federal Reserve earnings as a fiscal receipt. In the Banking Act of 1933, Congress accepted that the Federal Reserve’s receipts were “not to be construed as government funds or appropriated moneys.” This freed them from congressional budget control (Hackley, 1983, 2). Members of Congress have introduced legislation making the system subject to the congressional appropriation process or cancelling its debt holdings, thereby removing its source of income. The legislation has never passed, mainly because a majority prefers to maintain independence. In 1978, Congress approved the Federal Banking Agency Audit Act, providing for audit of some of the Federal Reserve’s transactions by the General Accounting Office. The act exempted transactions with foreign central banks and related to monetary policy actions (Hackley, 1983, 5). Since the Board lacks a source of earned income, the regional reserve banks pay an assessment to the Board.

Other aspects of independence are the non-renewable fourteen-year terms of Board members, the absence of Senate confirmation for presidents of Federal Reserve banks, commercial banks’ ownership (but not control) of Reserve banks, the reluctance of Congress to approve legislation making the chairman’s term coterminous with the president’s, and service by Reserve bank presidents on the policymaking Federal Open Market Committee (FOMC). Other instances include the provision that Board members may be removed only for cause, and the removal of the Secretary of the Treasury and the Comptroller of the Currency from the Board in 1935. Congress has reconsidered each of these issues, some many times, but has not made a major change to reduce independence.

Hackley (1972, 195) concluded that the Federal Reserve Board of Governors and the FOMC are agencies of the executive branch. It is a “creation of Congress but so are other executive agencies.” Hackley argues that the president appoints Board members and the Board, under congressional statutes, exercises governmental functions
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(ibid., 195). I have not found evidence that members of the Congressional Banking Committee share this view. Federal Reserve governors are asked frequently if they are the agents of Congress; the expected answer is yes.

One informal but powerful restriction on Federal Reserve independence is its presence in Washington, the political capital. Board members, especially the chairman, are conscious of political developments and pressure to accede to them. Federal Reserve policy was an issue in the 1960 election and again in 1980. Arthur Burns as chairman was unusually partisan. He met with President Nixon regularly. Other chairmen and governors met at times with administration officials both at regular meetings and less formally. Pressure from Congress increased in the 2007–9 crisis.

Several administrations used appointments to influence Federal Reserve decisions. On the other hand, some presidents honor independence. President Gerald Ford was exceptionally careful not to influence Arthur Burns. However, the minutes or transcripts of FOMC meetings contain very few references to politics. Partisan action would threaten independence, so it has usually been avoided.
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Wooley (1984, 109) concluded that “presidents generally get the policy they want from the Federal Reserve.” Presidents Ford, Carter, and George H. W. Bush would not accept that conclusion. It remains true that Presidents Eisenhower, Ford, Reagan, and Clinton were less intrusive than Presidents Johnson and Nixon. The result was lower inflation when the Federal Reserve was less subject to and less responsive to administration pressures.

The monetary and political authorities have not agreed on a definition of independence. Often System officials speak about “independence within government,” a convenient phrase that recognizes that independence is not absolute but leaves open where the limits of government authority li
e. The limits change. President Reagan wanted lower inflation and did not criticize Federal Reserve policy. His administration did not agree on what they wanted the Federal Reserve to do, so Chairman Volcker ignored them. He did not talk to Treasury Undersecretary Sprinkel and did not get along
with Secretary Regan. The first Bush administration frequently criticized Federal Reserve policy publicly, and Chairman Greenspan publicly criticized as an attack on independence a letter written by a Treasury official to the FOMC members urging a reduction in interest rates. The Clinton administration did not discuss monetary policy publicly and avoided putting pressure on the System.

18. Hackley was the chief legal officer of the Board.

19. Wooley (1984, 129) summarizes political influence: “There is almost no persuasive evidence that the Federal Reserve is actively engaged in partisan manipulation.” A finding that it engaged in political actions would probably end independence.

In practice, the Federal Reserve waited for political support before making major policy changes. Although members chafed under the 2.5 percent ceiling for long-term rates before 1951, they did not challenge the restriction until they had congressional support. In 1978 polling data showed a sharp increase in concern about inflation that persisted until spring 1982. More than 50 percent of those polled listed inflation and the high cost of living as the most important problem facing the country. In October 1978, 72 percent listed inflation and only 8 percent listed unemployment. The public wanted disinflation; the political process responded and the Federal Reserve changed its policy. By October 1982, when the disinflation policy ended, 61 percent listed unemployment as the most important problem. Only 18 percent still cited inflation.

President Nixon urged Arthur Burns to adopt more expansive policy prior to the 1972 election. Leading members of Congress agreed. The public expressed little concern about inflation. Only 20 percent listed inflation as their principal concern at election time.

Independence should be strengthened. Responsibility for policy outcomes should not be avoided in discussions of independence. An independent central bank can cause unemployment or inflation. The public generally blames the administration and Congress for these outcomes. They may lose office. Federal Reserve officials may be criticized, but they retain their positions. Following the two major errors of the twentieth century, the Great Depression and the Great Inflation, no Federal Reserve officials had to resign.

Responsibility and authority should be more closely aligned. At a Shadow Open Market Committee meeting in 1980, I proposed that the Federal Reserve Chairman and the Secretary of the Treasury should agree on the policy objective for the next two or three years. If the objective is not met, the president could ask for an explanation. He could then accept the explanation or ask for a resignation. Subsequently, several countries starting with New Zealand adopted variants of this proposal.

Inflation

The third major topic is inflation. Chapters 4 through 9 discuss four issues. Why did the Great Inflation start? Why did it take fifteen to twenty
years to reduce inflation to low levels? Why did it end? Why did high inflation not return in the next twenty years?

Modern central banks no longer claim, as the Federal Reserve did in the 1920s and even in the 1950s, that they do not control the inflation rate. They may have meant the near-term or quarterly rate but, if so, they failed to make that explicit. Academic research and experience settled the issue about the long term. It left open the practical issue of how to measure inflation and how to choose a value for an inflation target.

Chairman Greenspan would not announce a numerical objective. He defined the absence of inflation as the point at which the public ignored inflation when making decisions.
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President Poole of the St. Louis reserve bank favored a goal of “zero inflation properly measured” (Poole, 2005, 1). In practice, he proposed 1 percent inflation for an index that excludes “volatile food and energy prices” (ibid., 2).

Poole’s definition recognized that in the short term, different indexes give different information. Over the longer term this is less of a problem. One reason is that one-time price changes and changes in relative prices distort inflation measures in the short term but are less troublesome over the longer term.

Central banks that announce inflation targets choose measures of the sustained rate of price change. The price level is allowed to change in response to the many largely random changes in productivity, excise taxes, exchange rates, or other relative price changes. In economic textbooks, these problems do not appear. They are very real to central bankers.

Otmar Issing (2003, 21) pointed to the information problem and the need for judgment. When analyzing expected inflation “no simple rules linking policy to one or two privileged indicators can substitute for an accurate examination of shocks and a careful analysis of their potential for transmission into prices over a sufficiently extended span of time ahead.” This statement about short-term difficulty in interpreting data contrasts with his view about the longer term. “Money should grow at a rate that is consistent with trend growth in real output and the central bank’s definition
[sic]
of price stability” (ibid., 21)

One example of the difficulties that the Federal Reserve had in deciding on the expected rate of inflation came in 2002–3, when the FOMC became concerned about deflation. An economy with very large budget and current account deficits and positive monetary growth was unlikely to experience
deflation. And the deflations in 1920–21, in 1937–38, in 1960, and at other times show no evidence that deflation had significant negative, real effects. The 1929–33 experience differed because money growth declined faster than deflation, suggesting that deflation would continue. The expected deflation did not occur in 2002–3.

20. Pressed internally to give a quantitative measure, eventually he said 2 percent. The FOMC later adopted 1 to 2 percent but did not announce it, out of concern for congressional opposition to an inflation target.

Orphanides (2001, 2003a,b) reported the errors in inflation forecasts during the 1970s. All the errors in the second half of the decade were underestimates of the inflation rate, strongly suggesting model errors. The Federal Reserve had difficulty forecasting the inflation rate at that time and later. In the 1980s, Paul Volcker disparaged staff forecasts and did not rely on them. Alan Greenspan (2007, 437) concluded that short-term forecasts are much less accurate than long-term.

As Issing insisted, setting an inflation target is easy. Achieving it in the short run is difficult because of the lack of accurate models of short-run behavior, the difficulty of distinguishing permanent from transitory changes in current data, measurement problems, especially the natural rate of output, and the often large data revisions. During the period discussed in the chapters that follow, unwillingness to persist in anti-inflation policies— often influenced by political concerns and pressures—had a large role.

REGULATION AND SUPERVISION

Financial problems and panics are recurring problems. Almost all countries have de facto or de jure deposit insurance programs. Often large deposits are uninsured but are protected against loss. The insurance limit in the United States started at $2500 in 1934 and is now $250,000. Adjusting for inflation, the new limit is at least seven times the initial limit.

Even in the absence of political pressures to avoid depositor losses, government-insured deposits require the government to regulate insured financial institutions. Absent regulation and supervision, some financial institutions would take large risks. This is particularly a problem if the institution’s capital is impaired.

Financial regulation has two distinct functions. One is service as the lender of last resort—the lender willing to supply bank reserves when most other lenders will not. The other is portfolio regulation and supervision to limit risk taking, maintain prudent standards, and protect the payments system. This function now includes lending standards intended to protect low-income borrowers and to increase their access to consumer loans and mortgages.

In its ninety-year history, the Federal Reserve has never clearly defined its responsibility as lender of last resort or announced a strategy for responding to crises. It creates uncertainty by, at times, preventing failure
of banks and other institutions and at other times permitting failure while protecting the payments system. Examples of bailouts include First Pennsylvania, Continental Illinois, and Long Term Capital Management. At other times, it permitted failures such as Drexel Burnham and several Texas banks. But during the Latin American debt problems of the 1980s, it protected the money center banks and did not require them to report their losses. Of course, the market value of the banks’ shares fell as the market recognized the hidden losses.

Announcing a clear strategy tells financial institutions what to expect. It removes the uncertainty about whether there will be a bailout to prevent failures or whether the Federal Reserve will limit its action to preventing the spread of failures by providing liquid assets on demand against acceptable collateral. If the Federal Reserve makes the latter choice, prudent financial institutions hold collateral to prevent failure. This lessens the problem.

More than a century ago, Walter Bagehot urged the Bank of England to announce its strategy for responding to financial panics. He wanted the Bank to state publicly that it would lend freely at a penalty rate against adequate collateral. That strategy is as sound now as when he announced it.

The size of financial firms often appears as an excuse for bailouts. A policy of “too big to fail”—the policy followed in the United States— encourages giantism and risk taking by large institutions. These institutions should be allowed to fail like any other. Failure does not mean that the firm disappears. It should mean that management and stockholders lose. Unless insolvent, the firm is reorganized and continues under new management and owners.

Congress became dissatisfied with the way financial regulators acted. In 1991, Congress passed the Federal Deposit Insurance Corporation Improvement Act (FDICIA). FDICIA restricted bailouts by instructing regulators to close failing firms.

FDICIA is as close as the United States has come to announcing a strategy for responding to financial failures. Regulators, especially the Federal Reserve as lender of last resort, should make their strategy known and follow it.

Portfolio regulation and supervision went in two directions. After the 1970s, Congress eliminated many of the prohibitions adopted in the 1930s. Interest rate ceilings and restrictions of banking from other types of finance disappeared. Resolution of bank and thrift association failures required regulators to permit interstate branching and bank consolidation. But regulators received new powers over credit decisions especially affecting minorities and women.