• The Federal Reserve in the Nation's Service

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THE FEDERAL RESERVE IN THE NATION'S SERVICE
The Fed's Former Vice-Chairman Reflects on Our Central Bank

Relative to their economic importance, central banks must be among the least understood institutions in the world. I have been told, for example, that millions of Americans think the Federal Reserve is a system of government-owned forests and wildlife preserves where, I suppose, bulls, bears, hawks, and doves live together in blissful harmony. Having spent 19 months as the Fed's vice-chairman, I know this isn't the case.
The Federal Reserve is an institution that touches almost everyone, but is itself touched-or even seen-by relatively few. But its traces are everywhere:
- Every time you pay or receive paper currency, you are using Federal Reserve notes-that is, debt obligations of the Fed. Your checks are also probably cleared through a regional Federal Reserve Bank.
- When you read in a newspaper advertisement that a certain bank will pay you 5.7 percent on a certificate of deposit, or hear on TV that an automobile company offers 4.9 percent financing, you are seeing tangible evidence of the Fed's regulatory hand at work. But few people have any idea that the Fed tells banks and auto-finance companies how to calculate those numbers-and doesn't always get it right!
- The interest rates themselves, while set in free markets, are of course heavily influenced by the Fed's monetary policy. Most Americans are aware of this, but how many know how this black magic is performed?
- Even fewer people understand how the Fed's interest-rate decisions affect the overall economy, and therefore influence how many people will find jobs, how many will be laid off, how many businesses will succeed, and how many will fail. Most economists will attest that the Fed has far more influence over such matters than the President or Congress.
The Federal Reserve System has a governance structure that is at least odd, perhaps even byzantine. Most countries get by with one central bank, but we have 12. These regional Federal Reserve banks are, in a legal sense, private corporations-complete with presidents, boards of directors, and shareholders. While these corporations are highly profitable-to the tune of about $20 billion a year-their shareholders do not reap the benefits. Instead, the Fed's prodigious profits are turned over to the U.S. Treasury. Atop this organization sits a seven-member board of governors in Washington, D.C., whose members are not elected by stockholders, but rather are politically appointed.
So who does the Fed serve?
Congress and the President? Most certainly not. Although the Fed is a creature of Congress, and its governors are all presidential appointees, the Fed does not exist to do their bidding, which would make a mockery of the doctrine of central-bank independence.
The banks? To some extent, yes. The Fed is a bank for banks. It sells to them a variety of services, often in direct competition with private suppliers. The Fed is also deeply concerned with the health of the banking and payments systems, and will take strong steps to safeguard them whenever necessary. But it would be a great mistake-one the Fed does not often make-for the Fed to see itself as a service organization for banks.
The financial markets? As the nation's central bank, the Fed is the ultimate guardian of the financial system. In times of acute market distress, it stands ready to play its classic role as the lender of last resort. In normal times, it worries about the integrity of the markets, financial fragility, speculative bubbles, the value of the dollar, and a host of other things.
But none of this adequately describes the Fed's true constituency, which ought to be the entire nation. While on the Federal Reserve Board, I viewed myself as working for 260 million Americans. Given the central bank's broad reach and pervasive influence, no narrower constituency seems appropriate.
While a time-and-motion study of the daily lives of Federal Reserve governors would reveal that most of their efforts are devoted to bank-regulatory issues, broadly defined, it is monetary policy that puts the Fed in the news, and occasionally in the middle of a political maelstrom.
Just how is the fed supposed to serve the nation with its monetary policy? Under the Federal Reserve Act, as amended, Congress has directed the Fed to promote "maximum employment, stable prices, and moderate long-term interest rates." That sounds like three goals, but the phrase is often called the Fed's "dual mandate" because the interest-rate objective is considered redundant: price stability will almost certainly bring low long-term interest rates in its wake.
In the short run, employment is largely determined by the total spending in the economy. Because interest rates are one important determinant of that spending, the Federal Reserve, through its influence on market interest rates, also exerts considerable influence on employment. But the process takes time. As economists put it, monetary policy works with a long lag, typically a year or two.
Changes in inflation are in turn largely determined by the balance between total spending in the economy, which is heavily influenced by monetary policy, and the economy's capacity to produce, which is not. If spending falls short of productive capacity, as happens in a recession, inflation falls. If spending overshoots capacity, as last happened in 1989-90, inflation rises. But the lag between monetary-policy decisions and inflation is even longer than the lag between monetary-policy decisions and their effect on employment. First monetary policy affects spending, then spending affects inflation. The whole process takes more than two years.
The central dilemma of monetary policy is this: unless inflation is below the Fed's long-run target, there is a short-run tradeoff between the goals of maximum employment and stable prices. To push inflation lower, the Fed must make interest rates high enough to hold total spending below the economy's capacity to produce. But that cuts into employment. So monetary policy must strike a delicate balance. It's an excruciatingly difficult decision, with a great deal at stake.
Early in my term with the Fed, I allegedly stirred up a controversy at a Federal Reserve conference in Jackson Hole, Wyoming, by acknowledging this tradeoff explicitly. The subject of the conference was reducing unemployment, and, as a central banker, I thought it appropriate to address the role of central banks in that task. In my brief remarks, I noted that monetary-policy actions have a profound effect on employment, and I suggested that a central bank could do its part to achieve low unemployment by pushing a nation's total spending up to the level of its productive capacity, but not further. I observed that the Fed's dual mandate could reasonably be interpreted in precisely this way, and I endorsed that mandate as reasonable-rejecting the alternative of concentrating exclusively on price stability while ignoring unemployment.
Nothing I said at Jackson Hole was really controversial, nor even original. My views of monetary policy's role and of the tradeoff between inflation and unemployment were totally conventional. About a dozen financial journalists were present, and all but one of them heard it that way. But a representative of The New York Times decided that I had violated the sacred trust of central bankers by speaking a few obvious truths, and his story landed on the front page.
That began a media firestorm. For more than a month, a barrage of stories appeared in newspapers, magazines, over the financial wires, and on radio and TV. This is what can happen to a Federal Reserve governor who publicly states that the Fed should serve the nation's interest and not just the bond market's. But in my view, that is the only correct way to see the Fed's mission; it is not open to compromise.
Abundant evidence now exists that Keynes was right in the 1930s, when he observed that modern industrial economies are not sufficiently self-regulating. Total spending sometimes roars ahead of productive capacity, leading to accelerating inflation, or lags behind, leading to unemployment.
In principle, either fiscal policy (government spending and taxation) or monetary policy can serve as a balance wheel, propping up demand when it sags and restraining it when it races ahead. But in practice, monetary policy has become the only game in town. In both the United States and Europe, the need to shrink large budget deficits dictates reduced government spending for years to come, regardless of the state of the overall economy. With the fiscal arm of stabilization thus paralyzed, a central bank that concentrates exclusively on price stability by keeping interest rates high is throwing in the towel on unemployment.
The argument for the Fed's dual mandate is straightforward: the central bank exists to serve society, the public cares deeply about fluctuations in the pace of economic activity, and well-executed monetary policy has the power to mitigate fluctuations in employment. Fortunately, almost all central bankers accept this argument nowadays, notwithstanding some misleading rhetoric to the contrary.
It is sometimes argued that acknowledgment of the tradeoff between unemployment and inflation, and of the central bank's concern with each, would rattle the financial markets, which want to believe that the central bank cares only about low inflation. This is nonsense. Both market participants and the financial press know the score and are too sophisticated to be taken in by ritualistic rhetoric. One smart reporter told me he has learned over the years to ignore what the Fed says, but instead to watch what it does. I conceded that he was right, but it troubled me that the two were so different. They should be a matched set.
There is much talk at central banks all over the world about the importance of credibility, which my dictionary defines as "the ability to have one's statements accepted as factual or one's professed motives accepted as the true ones." Why, in particular, is it so important that "one's professed motives" be accepted as true? Because a central bank is a repository of enormous power over the economy. If the central bank is independent, this power is virtually unchecked. Such power is a public trust, assigned to the bank by the body politic. In return, the citizenry and their elected representatives have a right to demand that the bank's actions match its words. And match-ing deeds to words is the hallmark of credibility.
The Fed's role as the economy's balance wheel is terribly important because it palpably affects peoples' lives. It's the most important thing a central bank does for or to society; I felt that responsibility keenly every day I served as vice-chairman. Society, therefore, has a strong interest in seeing that the central bank does its job well. And evidence collected in recent years suggests that making the bank more independent should help.
Independence means, first, that the central bank is free to decide how to pursue its goals. This freedom doesn't mean the bank gets to select the goals by itself. On the contrary, in a democracy it is obligatory that the political authorities set the goals-and then instruct the central bank to pursue them. To be independent, the bank must have a great deal of discretion over how to use its instruments in pursuit of its objectives. But it need not set the goals.
Independence also means that the central bank's decisions cannot be countermanded by any other branch of government, except under extreme circumstances. In our system of government, neither the President nor the Supreme Court can reverse a decision of the Federal Open Market Committee. Congress can do so in principle, but only by passing a law that the President will sign (or by overriding his veto). This makes the Fed's decisions, for all practical purposes, immune from reversal.
Empirical evidence suggests that, over time, countries whose central banks have relatively greater independence enjoy lower inflation without suffering from slower growth. This finding is consistent with the view of most economists that there is a short-run tradeoff between inflation and unemployment, but no long-run tradeoff. This research raises a provocative question: Why, on average, do more independent central banks produce superior macroeconomic performance? I suggest three reasons.
First, as I noted earlier, the effects of a successful monetary policy take time, so good policy takes farsightedness and patience. Unfortunately, these are not the strong suits of the political process.
Second, and related to farsightedness, fighting inflation has the cost-benefit profile of a long-term investment: You pay the costs up front, and you reap the benefits only gradually over time. If politicians made monetary policy on a day-to-day basis, they would be sorely tempted to reach for short-term gains at the expense of the future-that is, to inflate too much. Many governments, therefore, wisely depoliticize monetary policy by delegating the authority to unelected technocrats with long terms of office, thick insulation from the hurly-burly of politics, and explicit instructions to fight inflation.
Third, and related to the issue of technocracy, the conduct of monetary policy is somewhat technical. Few elected officials have much understanding of how the mechanism of monetary transmission works, of the long lags I have mentioned, or of a variety of other technical details. So countries can probably get higher-quality monetary policy by turning the task over to trained technicians-subject, of course, to political oversight.
At this point, a deep question arises: Isn't all this profoundly undemocratic? I offer the following reasons why vesting so much power in unelected technocrats doesn't contradict democratic theory.
First, all democracies reserve certain decisions to what is sometimes called the "constitutional stage" rather than leaving them to the daily legislative struggle. These are basic decisions that we don't want to revisit often, and they should therefore be hard to reverse. For example, amending the Constitution requires much more than majority votes of both houses of Congress. Similarly, the Fed's independence-which derives from authority delegated by Congress-makes it very difficult, but not quite impossible, for elected officials to overrule a decision on monetary policy.
Second, a central bank's basic goals are defined by elected politicians. So, for example, when people suggest that the Fed should be content with 3-percent inflation, I answer: The Federal Reserve Act says "stable prices," not "pretty low inflation." If the citizens think that's wrong, they should get the law changed.
Third, the public has a right to demand honesty from its central bankers. Credibility means matching deeds to words. The central bank owes this to the body politic, in return for its broad grant of power.
Fourth, the central bank should be open and accountable. The Fed's monetary actions have profound effects on the lives of ordinary people, and it owes these folks an explanation of what it is doing and why. By offering a reasonably full and coherent explanation of its actions, a central bank can remove much of the mystery that surrounds monetary policy, and enable others to appraise its decisions and judge its success or failure. The Federal Reserve, tight-lipped as it is, is far from the worst offender in this regard, and in fact is probably more open and accountable than most central banks. But the competition in this league isn't stiff, and I believe the Fed could and should go much further.
Fifth, the leaders of the central bank should be politically appointed. When Janet Yellen and I went on the Federal Reserve Board in 1994, as political appointees of President Clinton, we joined Alan Greenspan, Mike Kelley, and John LaWare, who were originally appointed by President Reagan, and Larry Lindsey and Susan Phillips, who were sent there by President Bush. None of us was ever elected to anything; but Presidents Clinton, Bush, and Reagan were. We obtained our political legitimacy from the men who appointed us. They, in turn, got it directly from the voters.
Finally, decisions by central banks should be reversible by the political authorities, but only under extreme circumstances. As I mentioned, a Federal Reserve decision on monetary policy can in principle be overturned by Congress. And Fed governors can be removed from office for good cause. These mechanisms have never been used, but America is wise to have them in place. Delegated authority should be retrievable, not absolute.