Modest Thoughts on Central Bank Independence

Indications that the Trump Administration is considering nominating Moore and Cain to the Board of Governors of the Federal Reserve has stirred up an international controversy over the independence of central banks. Cain withdrew his name from consideration yesterday, though the mere floating of his name had generated much consternation. Although President Trump has appointed the majority of the Board, including choosing Powell as Chair, and they have not been controversial, he has used his bully pulpit to criticize the conduct of monetary policy repeatedly. Even the usually circumspect ECB President Draghi felt it necessary to express his concern.

Given the importance, let's unpack this concept of central bank independence. There seem to be four elements to consider, personnel, policy goal, instruments, and the policy decisions themselves. Critics of Trump have broadly complained about the caliber of appointments, but until now the Fed had been an exception. His appointments to the Federal Reserve have been well within the mainstream.

The policy goal was set by Congress. It is commonly talked about as if the Fed has a dual mandate. Fed officials themselves use such language. Yet the same amendment to the Federal Reserve Act clearly stated a third: moderate long-term interest rates. How can the Fed, which targets short-term interest rates, be responsible for moderate long-term interest rates? This is the shadow of financial stability, which the Dodd-Frank Act strengthened.

The Federal Reserve Act nor the amendments required the central bank to have a formal inflation target. It has great discretion in defining price stability and formally adopted a target of 2% for the headline deflator for personal consumption expenditures in 2012, almost 100 years after the central bank was founded. The Federal Reserve enjoys broad discretion over the tools. It did not need congressional approval to launch its asset purchase program, but it did require authority to pay interest on reserves (not just excess reserves, which is often cited).

Central banks have varying degrees of independence. The Bank of England, for example, was given an inflation target by the UK government and if it is outside of a specified range, the Governor is required to write a letter of explanation. Although it is one of the oldest and most revered central banks, its independence is a relatively recent development. Operational independence did not come until 1997 (under a Labour government and Gordon Brown as Chancellor of the Exchequer). The Bank of Japan is regarded as among the least independent of major central banks. The European Central Bank is the newest central bank, and it was designed to be the most independent.

The power of the central bank is great, and in representative governments, the power must be accountable. It is common for the major central banks to hold press conferences after their meetings, and starting this year, the Federal Reserve has adopted this practice itself. From time-to-time, it is not unusual for the heads of central banks to speak to the legislative branch. The Federal Reserve Chair speaks to each house of Congress twice a year.

Intervention in the foreign exchange market is decided often by the government, with the central bank executing the operation. In the US, the reserves are divided between the Treasury and the Federal Reserve. Although the Treasury Secretary makes the intervention call, custom dictates, that the cost is borne evenly by the Treasury Department and the Federal Reserve.

Trump is accused of encroaching upon the central bank's independence is two ways. First, although many candidates are being considered, the indication that Moore and Cain were among them was seen as politicizing the Fed. By "politicizing," many mean that those candidates would simply do Trump's bidding, which is to ensure the 10-year old expansion keeps ticking. But it is a time-honored principle that the President can pick people to serve him of like mind. Moreover, the power of appointment is one of the democratic elements of accountability. Second, Trump repeatedly violates an unwritten rule against the executive branch being critical of the central bank.

The power of appointment is checked by the approval of the Senate. While nominations are not rubber stamped, the president is given wide berth. Presidents should be expected to pick candidates who share their vision. It is not so much that both advocate easy monetary policy now that bothers so many economists and other observers. Instead, it is that both men are not seen as qualified. As noted this criticism has been levied against many of Trump's nominations and appointments.

There is a subtext here too. There is an assumption that economists should set monetary policy. Journalists along with others track how many economists are on the Federal Reserve and somehow more is thought to be better. One does not need to be an economist to have a nuanced understanding of monetary policy and a grasp of the linkages to the broader economy. A financial journalist and a businessman, in theory, could bring much to the table.

From a larger perspective, the populist moment is a backlash against the elites who have failed to deliver the goods--the rising living standards for us and our children--crystallized in the distribution of the costs of the Great Financial Crisis and its aftermath. The yawning disparity of wealth and income has grave political consequences. The Federal Reserve wields vast powers, and it is not transparent. Remember the Fed did not have press conferences after meetings until 2011 and then they were quarterly. Starting only this year a press conference will be held after every meeting as is customary for other major central banks, including the European Central Bank and the Bank of Japan.

In this populist moment, with the central bank more present, some argue that monetary policy has done more for the markets than the real economy over the past decade. It is true the stock market had rallied dramatically from the bottom in March 2009, but to say that monetary policy has done more for the markets than the real economy seems to be an exaggeration. Weekly jobless claims are at 50-year lows, and although rules for access have changed, the unemployment rate is also near half-century lows. Jobs are the number one source of income that fuels consumption, which around 2/3 of GDP.

The fact that wage growth is not stronger cannot be reasonably attributed to inadequate monetary policy. The Federal Reserve wants to see higher wages. After all, it is difficult to achieve its inflation target without stronger wage increases. The National Labor Relations Board has weakened employee rights, and the federal and state governments have often purposely sought to undermine the one institution whose raison d'etre is to give labor a greater share of the pie. The best thing for households is a strong economy, and monetary policy is one engine. Fiscal policy is another. Some would argue that because the fiscal policy was inadequate, monetary policy had to do more. The Fed has facilitated growth by having interest rates, when adjusted for inflation, below zero most of the past decade. Only last year did the nominal Fed funds target move above inflation, and now some argue that having positive real interest rates with sustained above-trend growth is somehow intolerably high.

It also seems exaggerated to claim that for "more than a generation the Fed has floated above politics," as a journalist does in the Wall Street Journal. It simply does not jive with the vignettes provided in memoirs and books of policymakers. It ignores the push to "audit the Fed" and begs the question of what finally propelled the Fed to move out of the shadows and have press conferences. There is also sometimes explicit sometimes implicit threat to alter the Fed's mandate or encroach on its discretion by forcing a Taylor-like rule, for example.

Also, the response to the Great Financial Crisis was unprecedented cooperation between the Treasury Department and the Federal Reserve. Now the lack of their coordination--for example the Treasury's debt issuance is facilitating a flattening of the yield curve that the Fed resists--is notable.

Conventional wisdom holds that large US budget deficits would cause inflation and higher interest rates. Neither had materialized. Modern Monetary Theory broadens the discussion of why this is possible and what it may mean for policy. Consider a parallel: Keynesian efforts to underwrite aggregate demand could focus on the construction of a social safety net or on defense and industries that feed into it. Voila, military Keynesianism. Similarly, arguments that a Green New Deal would undermine the Fed's independence and would necessarily be more inflationary than the tax cuts and spending increases seem to ring hollow.

Conventional wisdom holds that if a central bank's independence is endangered, inflation expectations will rise and the currency would come under pressure. Turkey is an obvious recent example. There is no sign that investors have become concerned that the Fed's independence has been compromised. The US dollar is strong, and interest rates are low. The commentariat exaggerates the threat, while Draghi's comments were gratuitous. He should have said that he was confident in America's institutional strength. At the end of the day, that, more than geography, is why the US is not Turkey.

We argue the Fed's independence is incomplete and it has been exaggerated in polemical zeal to show how far we have fallen. Ultimately, one does not want easy or tight monetary policy but a monetary policy appropriate for the economic conditions and outlook. All of the people appointed by Trump voted for the December 2018 rate hike. The power of appointment is not absolute. There is precedent for rejecting a president's candidates if they were judged unqualified or sufficiently out of the mainstream. We argue that despite the President's criticisms of the Fed, his call for a resumption of QE and his top economic advisor's call for 50 bp rate cut, the Fed's independence, such as it is, has not been violated. Over the past century, the Fed has established its institutional integrity. It is stronger than some presidential tweets and public criticisms.