Article: The Federal Reserve Needs To Be Boring Again

The Federal Reserve Needs To Be Boring Again
Thomas F. Cooley, 05.13.09, 12:01 AM ET
http://www.forbes.com/2009/05/12/federal-reserve-bernie-sanders-ron-paul-opinions-columnists-talf_print.html

Extraordinary times require extraordinary actions. Nowhere is that more apparent than in the bold policy moves undertaken by the Federal Reserve over the past two years. The financial crisis forced the Fed to be aggressive and creative in its attempts to provide liquidity to credit markets that had frozen up. These were necessary steps, and mostly applauded.

But the very boldness of its actions has put the independence of the Fed at risk. Congress is now clamoring to audit the Fed, and some of the policy proposals currently under discussion at the Federal Reserve will only increase the threat to its independence.

Before we deconstruct these issues, let's focus on why it is important to have an independent central bank. The answer is quite obvious. An independent central bank can focus on monetary policies for the long term--that is, policies targeting low and stable inflation and a monetary climate that promotes long-term economic growth. Political cycles, alas, are considerably shorter. Without independence, the political cycle would subject the central bank to political pressures that, in turn, would impart an inflationary bias to monetary policy.

On this view, politicians in a democratic society are short-sighted because they are driven by the need to win their next election. This is borne out by empirical evidence. A politically insulated central bank is more likely to be concerned with long-run objectives.

A variant of the argument for central bank independence is that control of monetary policy is far too important to put in the hands of politicians. As a group, they have repeatedly demonstrated the lack of political will power to make difficult economic decisions. But now they want to assert control over the Fed. Bills H.R.1207 and S.604, introduced, respectively, by Rep. Ron Paul and Sen. Bernie Sanders (who brought you the "Employ Americans First Act"), would assert greater control over the Fed. As Ron Paul writes on his Web site: "Auditing the Fed is only the first step towards exposing this antiquated insider-run creature to the powerful forces of free-market competition. Once there are viable alternatives to the monopolistic fiat dollar, the Federal Reserve will have to become honest and transparent if it wants to remain in business."

Great! Obviously, monetary policy is so falling-off-a-log simple that your elected representatives can insert themselves via the demand for transparency into decisions of true complexity and subtlety. Why am I not feeling reassured?

To a large extent, the Fed backed itself into this problem, and it has to find its way out. In the heat of the financial crisis, the Fed created a number of additional lending facilities and took a wider variety of non-Treasury assets onto its balance sheet. The goal was to provide liquidity for the financial system.

At first it sterilized these transactions by selling Treasury assets, but since September 2008 it has expanded its balance sheet dramatically from roughly $900 billion to over $2 trillion, as of May 6. This has had the effect of increasing the reserves in the system that are available for lending. The current plan is to continue to expand the balance sheet with the Term Asset-Backed Securities Loan Facility (TALF), the program designed to buy securities backed by credit card debt, auto loans, student loans, small-business loans and real estate loans.

This dramatic expansion of the balance sheet, together with the Fed's close involvement in the bailout of financial institutions like AIG and Merrill Lynch, have put the Fed in the spotlight. It is a problem precisely because if the Fed programs target particular asset classes, or industries or firms--which they do--then the Fed has put itself in the business of allocating credit. Their actions can also distort prices for these assets. This they should not do in general. Buying Treasury securities is completely neutral with respect to the allocation of credit. Buying securities backed by, say, auto loans, is not.

In late March, perhaps to forestall Congressional intervention, the Treasury and the Fed issued a joint press release that acknowledges this problem. It says explicitly that the Federal Reserve should not allocate credit to narrowly defined sectors or classes of borrowers, and pledges the Treasury to help the Fed remove some of the private assets from its balance sheet.

The presence of these assets on the balance sheet in such quantities creates another problem for the Fed that exposes it to intervention. First, these huge unborrowed reserves make some observers nervous about inflation, even though there is no evidence of it right now. But if the Fed has to reduce the assets on its balance sheet to forestall an inflation threat it could be very disruptive to credit markets. Their complicated positions could be hard to unwind. If the assets they bought were liquid, the Fed wouldn't have been buying them in the first place. This means it may be difficult to get the cash out of the economy before it is too late.

The Fed has been quietly surfacing a solution to this problem. In my view, it is ill-conceived and more likely than anything they have done to date to bring Congressional--and even public--wrath down upon them. The idea is for the Fed to issue its own debt, called "Fed Bills." The sale of such bills would have the effect of taking reserves out of the system. Traditionally, the Fed sells Treasury securities to take reserves out of the system, but under this proposal it would be issuing its own debt as way of shrinking reserves.

It is easy to understand why the Fed wants more tools to help it manage its massive balance sheet. The Fed began paying interest on reserves for precisely this reason. With interest on reserves, they can make it relatively more attractive for the holders of reserves to keep the money on deposit rather than lend it out. But issuing debt raises a whole additional level of complication.

There is an open question about whether the Federal Reserve even has the authority to issue claims other than currency. Apparently it thinks it does. But is it even remotely credible that the Fed could have the unbounded authority to borrow money and buy assets without the inconvenience of having to explain itself on Capitol Hill?

Anything that threatens the independence of the Fed threatens the long-term viability of monetary policy. It is really important that the expanded role of the Fed in the current crisis not threaten that viability. An independent Fed can pursue policies that are politically unpopular yet in the public interest. We need central banking to be boring again, not something that keeps us on the edge of our seats.

Thomas F. Cooley, the Paganelli-Bull professor of economics and Richard R. West dean of the NYU Stern School of Business, writes a weekly column for Forbes. His columns are archived here.