Economics of Federal Reserve Independence (CRS Report for Congress)
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| Release Date |
April 17, 2007 |
| Report Number |
RL31056 |
| Report Type |
Report |
| Authors |
Marc Labonte, Government and Finance Division |
| Source Agency |
Congressional Research Service |
Summary:
The Federal Reserve System (Fed) is charged with responsibility for making U.S. monetary policy. Quasi-public in structure, overseen by a Board of Governors whose members are appointed to serve long terms, and reliant on its own source of funding, the Fed possesses a degree of independence that some argue is inimical to the spirit of democracy. Although this argument (and refutations of it) may be political or constitutional in nature, it is also rooted in certain notions about macroeconomic policy.
The power that the Fed wields is substantial. Along with fiscal policy, monetary policy is one of two kinds of policy that can be employed to influence aggregate demand. In the short run, both monetary and fiscal policy have the power to raise or lower employment. But they have opposite short-run effects on interest rates (expansionary monetary policy lowers interest rates and expansionary fiscal policy raises them), so that in concert they can achieve results that neither can in isolation. The long-run effects of the two policies are quite different from their short-run effects. Fiscal policy helps determine interest rates in the long run, but not the rate of inflation. Monetary policy largely determines the inflation rate, but cannot be used to fix interest rates in the long run. Policies based on the assumption that monetary policy can fix interest rates ultimately generate accelerating inflation or deflation.
Monetary policy affects inflation only after it affects employment. A policy structure that responds quickly to the immediate concerns of the public is thus more likely to generate inflation than one that allows policymakers to more easily weather bad times. A very responsive policy structure not only increases the likelihood of high inflation. It also tends to produce more business cycles if policy directed at reducing inflation is aborted before it is complete, only to be reintroduced again later when the renewed expansion makes inflation worse. On-again, off-again policies erode the credibility of the monetary authorities and make anti-inflation policy all the more costly and lengthy when it is undertaken in earnest.
Reducing the independence of the Fed either means reducing the ability to engage in discretionary policy or shifting economic power to the executive branch. This is an important consideration given the difficulty in calibrating policy. Because the legislative branch is not in a position to exercise day-to-day control of monetary policy, if it wishes to reduce the Fed's discretionary powers, it must choose between establishing policy rules to which the Fed must adhere or allowing the executive to administer policy. Economists who oppose rules fear that they would be too rigid to deliver economic stability in a highly complex economy.
Better coordination of monetary and fiscal policy is a double-edged sword. If "good" policy is pursued, it will be all that much better if simultaneously pursued with both tools. But if "bad" policy is pursued, using both tools to pursue it will make the result that much worse. Thus, the choice boils down to whether the policy structure should be one that maximizes the benefits that come from policy when it is well chosen or minimizing the costs that occur when policy is ill-advised. This report does not track legislation and will be update as events warrant.
