Central Banking after the Great Recession: Lessons Learned, Challenges Ahead

Federal Reserve Indpendence after the Financial Crisis: Shoud We Be Worried?

5 Federal Reserve Independence after the Financial Crisis Should We Be Worried? Donald Kohn 91 We are going through an extraordinary period in business cycles and central banking. The too-calm, too-confident veneer of the Great Moderation was shattered by the worst financial crisis in eighty years. The Federal Reserve—indeed central banks all over the industrial world— took extraordinary actions to make sure the crisis was not followed by an economic result like that of the 1930s, and they continue to pursue policies that not so long ago would have been considered unthinkable. Naturally, understandably, and appropriately, these circumstances have increased the scrutiny of central banks and raised questions about the goals, governance, and accountability of these institutions. The issue before us is whether we should worry that this scrutiny will result in an erosion of their independence from the elected government. We should be concerned about the potential for reduced independence: evidence over time and across countries indicates that less independence is correlated with higher inflation.1 To foreshadow my answer: the actions that the Federal Reserve and other central banks took should not and need 1.See Bernanke (2010) and the references in that speech. 05-2608-1 ch5.indd 91 3/11/14 9:55 PM 92 DONALD KOHN not lead to a loss of monetary policy independence, but we need to be vigilant. The risks and threats to independence have increased. The wisdom of a high degree of independence for central banks in the conduct of monetary policy is well established. Goals for policy are and should be set in the democratic process by elected representatives . The Federal Reserve Act, as amended in 1977, charges the Federal Reserve with pursuing “maximum employment, stable prices and moderate long-term interest rates.”2 The primary objective of the European Central Bank, by treaty, is “to maintain price stability.”3 Independence is critical in the setting of the instruments—interest rates and the like—to achieve these goals. Central banks should be held ultimately accountable for outcomes, and not for the techniques they used to get to those outcomes. Instrument independence is necessary to overcome the short-term perspective of politicians, who tend to be more interested in boosting economic growth before the next election and less focused on the longer-term inflationary consequences of such actions. This view is widely shared around the globe, as evidenced by the lengthening lists of central banks that are, in this sense, independent of the elected government. Of course, instrument settings are subject to public discussion and legislative hearings. That is key to holding the independent central bank accountable. The Federal Reserve or any other independent central bank needs to explain how its actions are related to the achievement of its objectives. And those discussions and hearings will involve political pressures —alternative views about interest rates or the size and composition of the central bank’s balance sheet. An independent central bank—one that has been insulated from these pressures—doesn’t need to follow the politicians’ instructions. It should resist where those desires are inconsistent with its own views of how to achieve the objectives. The legislative framework for monetary policy can be changed, of course, and it can be changed in ways that impinge on a central bank’s instrument independence and thus its ability to achieve its mandate. Proposals to alter the Federal Reserve’s mandate or its governance surface 2.For a brief history of the Federal Reserve’s mandate, see Steelman (2011). 3.See Article 127, “Consolidated Version of the Treaty on the Functioning of the European Union” (http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:C:2012:326:004 7:0200:EN:PDF). 05-2608-1 ch5.indd 92 3/11/14 9:55 PM Federal Reserve Independence after the Financial Crisis 93 regularly in Congress, though few have garnered substantial support and none has actually been passed since the late 1970s. But the crisis and the actions the Federal Reserve felt compelled to take during the crisis weakened public support for the institution and its independence, and led to some unusually stiff attacks from prominent politicians. To reprise briefly, during the crisis the Federal Reserve expanded access to the discount window for banks and opened credit facilities to non-banks for the first time since the 1930s. It helped stabilize or facilitate the takeover of systemically important institutions at...