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This commentary was written by Dr. Daniel Thornton of D.L. Thornton Economics. Thornton spent over three decades at the St. Louis Fed as vice president and economic advisor.

Requiem for Fed Independence - 01.12.2018 FED process cartoon  2

Economists believe that central bank independence is essential to fend off demands by the president or Congress to help finance the debt by keeping interest rates low or by increasing the money supply.

Hence, central banks must be independent in order to do their job of stabilizing prices and output. NOTE: Independence in this sense does not imply central banks are not accountable for their actions; nor does it imply central banks need to be completely transparent, see my Monetary Policy Transparency: Transparent About What?

Moreover, there is a well-defined line between monetary policy and fiscal policy. Monetary policy focuses on stabilizing prices and output by adjusting the money supply and/or affecting interest rates. Fiscal policy deals with deficit spending in times of recessions or crises. It does not involve deficit spending for social programs, defense build ups or other reasons. This essay gives a brief history of Fed independence, and the Fed’s path to ending it.

I begin this essay by noting that the Fed formally gave up its ability to conduct independent monetary policy during World War II when it entered into a formal agreement with the Treasury to keep the Treasury bill rate at 0.375 percent. Given this constraint, the Fed was unable to conduct an independent monetary policy. When the war ended, the Fed wanted to regain its independence. There was considerable resistance. President Truman and Secretary of the Treasury, John Snyder, didn’t want interest rates to increase. In spite of the Fed’s effort to keep the T-bill rate at 0.375 percent after the war, the rate began to increase in July 1947. It had increased to 1.4 percent when the Fed regained its independence on March 4, 1951, with an agreement known as the Treasury-Fed Accord.

I have argued here and here that the Federal Open Market Committee (FOMC) unwittingly threatened its independence when Greenspan decided to use the federal funds rate as its policy instrument circa May 1988. My rationale is simple. If the Fed controls the federal funds rate, it will get pressure from the president whenever it increases the rate or fails to reduce it when the president wants it to. All presidents have applied pressure on the Fed at times, but President Trump is the first to do it in a very public way.

At the July 1997 meeting, Richmond Fed President, Al Broaddus, raised concerns about the pressure saying, “putting a pretty face on a funds rate increase is a tough sell when we are dealing with the media or Congress or the general public for that matter.” Greenspan responded to Broaddus by describing the evolution of his decision to use the federal funds rate as the policy instrument saying:

I think we were well aware of that would happen when we shifted to an explicit federal funds rate target. As you may recall, we fought off that apparently inevitable day as long as we could. We ran into the situation, as you may remember, when the money supply, nonborrowed reserves, and various other non- interest-rate measures on which the Committee had focused had in turn fallen by the wayside. We were left with interest rates because we had no alternative.

I think it is still in a sense our alternative. I think it is still in a sense our official policy that if we can find a way back to where we are able to target the money supply or net borrowed reserves or some other non-interest measure instead of the federal funds rate, we would like to do that. I am not sure we will be able to return to such a regime...but the reason is not that we enthusiastically embrace targeting the federal funds rate. We did it as an unfortunate fallback when we had no other options, and I think the consequences are much as we anticipated.

Greenspan went on to say we should just say what we did and why we did it. This is not as simple as Greenspan made it sound. The president, Congress, the media and the public may not be able to appreciate the reason for the FOMC’s action. All they know is the Fed decided to raise interest rates. Moreover, while a well-respected chairman like Greenspan, aka, the Maestro, can get by with this, other chairmen may find it more difficult. Likewise, the effectiveness of this approach is likely to vary with the president: President Trump wasn’t accepting any explanation for the Fed’s inaction.

Ben Bernanke took a big step closer to killing the Fed’s independence by crossing the line between monetary policy and fiscal policy. This first occurred on November 25, 2008, when the Board of Governors (not the FOMC) announced the Fed would purchase $500 billion of mortgage-backed securities (MBS) to support the housing market. At his urging, the FOMC agreed to purchase MBS. Bernanke had proposed other non-monetary policies the Fed might enter into, but got considerable pushback from most of the Reserve Bank Presidents who believed credit allocation was the Treasury’s job, i.e., fiscal policy. In the end the Committee agreed to limit its purchases to Treasuries, agency debt, and Freddie and Fannie guaranteed MBS.

The Fed has taken an even larger step into conducting fiscal policy in response to the coronavirus. It not only enacted the alphabet soup of special programs that it used in response to the financial crisis, but added several more. Furthermore, it has agreed to purchase corporate and state and local government bonds. There is effectively no limit on the kind of assets the Fed can purchase under the guise of stabilizing financial markets. When the coronavirus crisis ends, there will be nothing to stop the Treasury or Congress from calling on the Fed to purchase auto-backed or student loan-backed securities if these markets begin to collapse, which could easily happen. Bernanke rejected the Bush administration’s request to bail out the auto industry during the last financial crisis, but the Fed will find it much more difficult to fend off such a request the next time.

Charles Plosser, former president of the Philadelphia Fed, argued here that the Fed’s assistance would be fine if the Treasury acknowledged the Fed’s independence by replacing the non-Treasury debt the Fed took on during the crisis with Treasuries. Charlie reiterated this in a recent CNBC interview, here. I agree.

We need a second Treasury-Fed Accord. It didn’t happen after the financial crisis. I don’t expect it to happen this time either. As of April 15, 2020, the Fed held $5.4 trillion in debt of which $1.6 trillion was non-Treasury debt. By the time the coronavirus crisis ends, the amount of non-Treasury debt will likely double, perhaps triple. By the time this crisis ends, the federal government debt will likely increase by at least $3 to $4 trillion. Hence, the Treasury will be reluctant to swap out the Fed’s non-Treasury debt with Treasuries, even if the Fed asked.

The Fed didn’t ask last time. It won’t ask this time either. For one thing, the Fed is likely looking for a reason to exist. The Fed’s financial crisis policies—keeping the federal funds rate at zero 6.5 years into the economic expansion, purchasing trillions of MBS and other debt, forward guidance and the rest—are increasingly viewed as ineffective. They had no noticeable effect on the level of output, and absolutely no effect on the economy’s growth rate. Hence, the FOMC may continue to engage in fiscal policy for the same reason the Greenspan Fed decided to use the funds rate as its policy instrument—they don’t know what else to do!

I believe the only thing that could change the Fed’s trajectory is high inflation like we experienced during the Great Inflation of the 1970s and early 1980s. But rapid inflation is nowhere in sight. In spite of a more than a decade-long historically easy monetary policy, the Fed has been unable to raise the inflation rate up to its 2% target level. If inflation were to get going again, I’m not sure the Fed knows how to stop it. 

EDITOR'S NOTE

This is a Hedgeye Guest Contributor piece written by Dr. Daniel Thornton. During his 33-year career at the St. Louis Fed, Thornton served as vice president and economic advisor. He currently runs D.L. Thornton Economics, an economic research consultancy. This piece does not necessarily reflect the opinion of Hedgeye.