Can the Fed stay independent?

By Robert Samuelson

 

It’s unclear whether one or both, or neither, of President Trump’s selections for the Federal Reserve Board — Stephen Moore and Herman Cain — will win Senate confirmation. What is clear is that this is a teachable moment concerning the Fed’s vaunted “independence.”

If you think it means that the Fed can do whatever it wants and is truly independent in law and deed, then you are woefully misinformed. But if you think the Fed is simply a political lackey of the president or Congress, then you are also misinformed.

The defining traits of the Fed’s “independence” are its ambiguity and flexibility. It is an elastic concept, meaning different things at different times for different reasons. The Fed’s basic tools are its ability to set short-term interest rates (the so-called fed funds rate on overnight loans) and to influence long-term interest rates (mortgages, government bonds).

These and other powers were delegated to the Fed for two reasons.

First, monetary policy — altering interest rates and credit conditions — is highly technical. Most members of Congress don’t have the time or the temperament to immerse themselves in the murky details.

Second, and more important, these decisions are often highly unpopular. Sometimes raising short-term rates is the right thing to do for the long-run — containing inflation or financial speculation — even if the immediate effects are unpleasant. Presidents and Congress wish to insulate themselves from a public backlash by deflecting criticism to the Fed.

As Sarah Binder and Mark Spindel observe in their recent book, “The Myth of Independence — How Congress Governs the Federal Reserve”:

“Congress depends on the Fed both to steer the economy and absorb public blame when the economy falters. … [B]y centralizing power in the hands of the Fed, lawmakers can more credibly blame the Fed for poor economic outcomes, insulating themselves electorally and potentially diluting public anger at Congress.”

Sometimes, the White House and Treasury’s mastery of the Fed has been almost absolute. Consider World War II. The Fed kept interest rates artificially low to finance defense spending (rates were 2.5% on long-term debt, less than 1% on one-year bonds and less than 0.5% on 90-day bills).

“The war brought [the Fed] squarely under presidential control,” writes Peter Conti-Brown in “The Power and Independence of the Federal Reserve.”

After the war, the Fed and the Treasury quarreled over whether the low rates should continue. President Truman preferred the status quo, but the Fed feared that would lead to higher inflation. The issue was settled by the famous Fed-Treasury Accord of 1951, which freed the Fed from the artificially low wartime rates.

For the next three decades, the Fed played second fiddle to White House notions of expansive economic policy. In 1965, President Johnson excoriated then-Fed chairman William McChesney Martin for raising interest rates. Later, President Nixon badgered Arthur Burns, Martin’s successor, to keep rates low to aid his reelection in 1972.

These policies were a disaster. Wage and price inflation rose steadily. By 1979, average weekly wages were rising 7%, though after correction for price inflation, they declined almost 4%.

This led to a basic change in policy. Under Paul Volcker, the Fed increased interest rates and squeezed the money supply to smother inflation. It worked; from 1980 to 1983, consumer price inflation dropped from 13% to 4%. President Reagan’s support gave Volcker the time for his austerity to kill inflationary psychology. Monthly unemployment peaked at 10.8% in late 1982.

In 1987, Alan Greenspan replaced Volcker but kept his basic policies. President Clinton decided not to criticize the Fed. In practice, this meant honoring the Fed’s “independence” to make short-run decisions on interest rates without White House interference.

But it was still not separate from the rest of government. A case in point: the 2008-09 financial crisis. Under Ben Bernanke, the Fed cooperated with the Treasury Department during the George W. Bush and Barack Obama presidencies. The idea that the Fed was so “independent” that it shouldn’t work with the rest of government was nonsense.

The question now is whether the pendulum is swinging back to more control over the Fed. The case against Trump’s picks for the seven-member Board of Governors — Moore and Cain — assumes that they lack the necessary background. But by itself, this isn’t disabling. Fed governors have always been of varying quality. Cain has been a businessman, and Moore a conservative public policy advocate.

The more relevant objection is that they would politicize the Fed, because they would be more loyal to Trump than to the Fed. Given Trump’s enthusiasm for smashing norms and humiliating adversaries, the threat to the Fed’s integrity must be taken seriously. If Trump maneuvered someone like Moore — a fierce partisan — into the chairmanship, it would cast a dark shadow over economic policymaking.

 

(c) 2019, The Washington Post Writers Group