US representative Barney Frank, the co-author of the Dodd-Frank Act and the former chair of the House Financial Services Committee, has recently tabled measures that, if passed, would mean the presidents of the regional Federal Reserves would no longer be voting members of the Federal Open Market Committee (FOMC).
Under the banner of “democratising” decision making in the Fed, the measures, H.R. 1512, have many flaws. They eliminate regional perspectives and further degrade the role of the 12 district banks. Most seriously, they would significantly enhance the politicisation of Fed policy at a critical time in US history.
The FOMC is already dominated by the Washington-based Board of Governors (seven board members make up 12 of the voting FOMC members and the chair of the Board is chair of the FOMC).
Despite staggered and 14-year terms, the Board has at times been far too sensitive to political pressures resulting in much economic and financial distress in the United States . The Great Inflation from 1965 to 1985 was largely due to Federal Reserve policy errors traceable to close relationships between chairs William McChesney Martin and Arthur Burns and the federal government. Martin believed the Fed was “independent within government” and supported the more activist fiscal policy of the Kennedy and Johnson administrations. Burns believed the cost of disinflation was politically too high and instead supported price and wage controls to reduce inflation and then used monetary policy to support the Carter administration and enhance his chances for remaining chair of the Board. Allan Meltzer’s recent history of the Federal Reserve documents how Federal Reserve policy became politicised under Martin and Burns (Thomas F. Cargill, “Meltzer’s History of the Federal Reserve: A Review Essay”, International Finance , 14 (Spring 2011): 183-207).
The Fed, despite its de jure independence, during the Great Inflation abdicated independent monetary policy designed to stabilise the price level and became de facto dependent on the federal government as it accommodated government spending and deficits. The costs of de facto dependence were high: high and fluctuating inflation rates, high unemployment, disintermediation of funds from indirect to direct finance, and ultimately the collapse of the Savings & Loan industry in the late 1980s. The Fed regained its de facto independence under the direction of chairs Paul Volcker and Alan Greenspan because the political environment supported price stability and the economy performed well through the start of the new century. Times have changed. The economy is not doing well despite unprecedented government deficit spending and monetary ease. The political class, especially the Obama Administration, will likely not tolerate any meaningful exit policy by the Fed that leads to higher interest rates despite many statements by the Federal Reserve it has the flexibility to deal with any inflation problems that may arise in the future. The political economy environment of Fed policy is becoming less conducive to de facto independent monetary policy focused on price stability.
Frank’s measures, if passed, would lower both the Fed’s de jure and de facto independence, destabilise the value of money and reduce potential growth by placing Fed policy under the influence of the political class. History has shown de jure independence of the Fed is no guarantee against de facto dependent monetary policy.
Yet the measures have little chance of becoming law and one wonders why Frank introduced the bill and why the Fed has largely been silent on a proposal that would fundamentally change its structure. Little effort went into preparing the two-page bill. The bill, however, can be viewed as a warning shot to the Fed not to permit interest rates to increase by placing too much attention on price stability and thereby threatening the fragile recovery. More importantly, it can be viewed as a warning shot not to threaten the re-election prospects of President Obama. The lack of Federal Reserve reaction to the proposals with the notable exception of Thomas Hoenig, the president of the Federal Reserve Bank of Kansas City, might reflect the tacit support of certain Board members. They may not appreciate the opposition to current Fed policy expressed by Hoenig who dissented at all eight FOMC meetings last year, or appreciate the widely cited speech in Santiago, Chile by Charles Plosser, the president of the Federal Reserve Bank of Philadelphia, who warned Federal Reserve policy was assuming responsibilities for which it could not fulfill and invoked Milton Friedman’s admonishment about the limits of monetary policy.
It is difficult to judge which is worse – the measures from Frank, an individual who played a major role in supporting and then protecting Freddie Mac and Fannie Mae, the failures of which were all too predictable, or the silence of the Federal Reserve. In either case the measures manifest an unfortunate trend toward the politicisation of monetary policy in the United States.
Thomas F. Cargill is a professor of economics at the University of Nevada, Reno