Let form follow function: In defence of central bank independence

Michael Orlando

24 May 2008

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As the effects of the subprime lending (or borrowing, as you prefer) binge continue to wear on the U.S. economy, politicians have reacted with a questionable set of proposals to ease the pain: from adjustable rate freezes to builder subsidies to liquidity access for lenders, it appears that no idea is beyond consideration. A more significant debate is taking form, however: a debate over the merits of central bank independence. Although opinions of the Fed’s role in the present crisis will vary, central bank independence can facilitate a monetary authority’s primary objectives of price stability and lender-of-last-resort in times of crisis. A clear understanding of the financial and economic policy functions necessary to achieve those objectives is important for determining the limited set of functions that should remain beyond direct political control.

The effects of the subprime lending meltdown began a year ago. The Fed’s interest rate setting committee first acknowledged slowing economic activity in a statement released on 9 May 2007. Treasury yields surged in June after trending higher over the prior two months. The first monetary policy interventions began in August, with the U.S., Japanese, and European central banks injecting over $350 billion in liquidity in order to stave off a credit market freeze-up. The Fed continued adding economic and financial stimulus over the next several months, culminating in the unprecedented measures observed in March.

Coincidentally, the U.S. Treasury Department released the Blueprint for a Modernized Financial Regulatory Structure on March 31. Incorporating the findings of a yearlong study on capital market competitiveness, the Treasury plan outlines a financial regulatory system that will “attract capital based on its effectiveness in promoting innovation, managing system-wide risks, and fostering consumer and investor confidence”. The Department presents a host of recommendations to be implemented over the near and intermediate terms, ultimately culminating in three objectives-based regulators. A new business conduct regulator would ensure consumer protection. A new prudential regulator would ensure the safety and soundness of institutions with financial guarantees. And the Federal Reserve would be assigned the objective of ensuring overall financial market stability.

The importance of independence

It is natural to focus on recent events as we begin to evaluate these proposals. Some believe the Fed deserves a share of the blame for the present crisis. In a quote to the New York Times, University of Maryland Law Professor and former Commodity Futures Trading Commission official Michael Greenberger argued that “[the] Fed oversaw this meltdown”. He equates the Fed’s role in the Blueprint to asking “the builders of the Maginot line [to give] lessons on defence”. Others will argue that the Fed has managed the crisis effectively. They may agree with former Chairman Greenspan, who has argued that bubbles cannot be identified in advance. From this viewpoint, the Fed should focus on mitigating the consequences of bubbles when they do occur. Regardless of how history ultimately judges the Fed, the important question for the emerging regulatory debate is about the scope and independence of a monetary authority.

The Federal Reserve is perhaps the most operationally independent governmental institution in the U.S. Governed by both publicly appointed officials (the Governors of the Federal Reserve Board) and privately appointed officials (the Presidents of the twelve Reserve Banks), the U.S. central bank is under less direct political control than any cabinet-level agency. Moreover, the Fed is entirely self-funded. With costs well below revenue earned on a portfolio dominated by U.S. Treasury securities, the Fed operates beyond the routine budgetary discretion of the Congress. While such independence is disconcerting to some observers, there are very good reasons to desire an independent central bank.

The Fed’s role

The primary long-run objective for monetary policy is to manage a stable currency value. A monetary authority should strive to ensure that there is enough currency flowing through the economy in order for good ideas to get funded, but not so much currency that bad ideas are attracting funds, bidding up the prices of capital and labour that could be used by the good ideas. Price stability is largely achieved through open market purchases and sales of U.S. Treasury Securities implemented to achieve the Federal Funds rate target on interbank lending and discount window lending at the Federal Reserve discount rate. However, these mechanisms can also be used to provide a temporary boost to economic activity. Consequently, confidence that these mechanisms will only be used to achieve the important goal of price stability is facilitated by independence from short-term political considerations.

The primary short-run objective for monetary policy is to serve as the lender of last resort in times of crisis. The monetary authority should ensure that localised liquidity crises do not become system-wide problems that can persist over the longer term. The Federal Reserve’s use of the discount rate and open market operations can serve this purpose. For example, as the present crisis began to unfold, reductions in the Federal Funds rate target and the discount rate did double duty, encouraging lending in response to declines in real economic activity and providing liquidity to a financial system scarce of credit.

Past events have demonstrated that control over a large-value payments system is another mechanism that is important for providing liquidity in times of crisis. The Fed’s large-value payment system, Fedwire, is an electronic network used to transfer funds between banks in real time. Former Vice Chairman Roger Ferguson has argued that the Fed’s ownership of Fedwire provided credibility to commitments by the Fed to deliver liquidity in the moments following the September 11 terrorist attacks. Absent a belief that the Fed could deliver on its promises, banks around the country might have begun hoarding cash for fear that the attacks on the nation’s financial centre would make it difficult for counterparties to keep their financial commitments. Thus, control over a large value payments system is important for providing liquidity in times of crisis.

Finally, recent events have demonstrated that the Fed may find it necessary to employ new and innovative approaches to target liquidity injections in times of crisis. For example, on December 12 the Fed established a new program to allow discount window borrowers to bid for additional liquidity extended for a fixed period of time. On March 11, the Fed established a program to lend U.S. Treasury securities against a pledge of other, presumably lower quality assets. And on March 16, the Fed initiated another new program to lend directly to primary dealers of government securities. Along with the Fed-arranged marriage between Bear Stearns and JPMorgan Chase, these programs merit continued debate and analysis. However, it is not obvious that the Fed’s ability to respond to this crisis in a timely and effective manner would be enhanced by more immediate legislative or executive oversight.

The Fed’s future

The debate over a new financial regulatory structure is just beginning in the U.S. An important part of that debate will define the future of the Federal Reserve System. Because the Fed’s ability to achieve its primary objectives is facilitated through institutional independence, this principle should remain paramount. However, the proper institutional design cannot be determined by debating abstract principles. It can only be identified through a detailed consideration of the type of work that should occur in a central bank. The most compelling proposals for monetary policy effectiveness, and for the future of central bank independence, will limit the Fed’s scope of authority to those functions necessary to achieve price stability and limit the impact of financial crises when they occur.

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Topics:  Monetary policy

Tags:  Federal Reserve, subprime crisis

Principal of Economic Advisors, Inc and former Vice President and Branch Executive of the Kansas City Fed's Denver Branch.

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