Economics of Federal Reserve Independence

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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.

Introduc tion ..................................................................................................................................... 1
Structure of the Federal Reserve System.........................................................................................1
Backgr ound ............................................................................................................................... 1
Current Structure.......................................................................................................................2
The Goals of Monetary Policy........................................................................................................3
Differences Between Fiscal and Monetary Policy....................................................................4
Policy Calibration, Lags, and the Role of Credibility...............................................................5
Criticisms of Independence.............................................................................................................6
Independence............................................................................................................................. 6
Coordinati on ................................................................................................................... ........... 8
Accountability and Disclosure................................................................................................10
What If Rules Replaced Discretion?........................................................................................11
Conclusion ..................................................................................................................................... 13
Author Contact Information..........................................................................................................14

The Constitution grants Congress the power to “coin money, and regulate the value thereof....”
Congress has delegated responsibility for making U.S. monetary policy to the Federal Reserve
System (Fed). This latter arrangement is one that many observers have criticized. Quasi-public in
structure, overseen by a Board of Governors whose members are appointed to 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. Debates concerning the ability of the
Fed to control interest rates, the need for coordination of monetary policy and fiscal policy, or
even the importance of monetary policy, underlie the arguments for and against independence,
and are matters of economic analysis.
Thus, in undertaking a discussion of whether the Fed should have more or less independence or
accountability, it is essential to understand how monetary policy works, and its role relative to
fiscal policy. Without this knowledge, it is possible that a decision to change the structure of the
Fed would fail to bring about the economic effects desired, or would bring about other, adverse,
effects not expected by advocates of the change.
This report¹ gives a brief description of the structure of the Fed. It then discusses the economics
of how Fed independence affects monetary policy. The report does not consider how Fed
independence may affect the Fed’s other duties, such as its oversight of the financial system. It
then examines the probable economic ramifications of proposals to curb the independence of the
Fed.

While there are many economic arguments supporting Fed independence, it is interesting to note
that none of these arguments—nor the primary duties of today’s Fed that underlie these
arguments—existed when the Fed was founded. Yet its structure today was largely determined in
its earliest years.
The Federal Reserve System was created largely in response to the panic of 1907 and the many ^th
banking panics of the late 19 century. This is ironic, since the Fed later presided over the
country’s worst series of banking panics in 1930-1933; federal deposit insurance would have to
be created to prevent a reoccurrence of banking panics. Moreover, part of the Fed’s original
mandate, to create an “elastic currency,” is believed to be an expression of the “real bills
doctrine,” a notion held in low regard within the economics profession today. As one author ²
states, it is “high on the list of longest lived economic fallacies of all time.” Its job now, to

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conduct monetary policy, was not believed by most experts at the time of its creation to be a
proper or even possible function of government. Before the 1930s, macroeconomic stabilization
policy was not widely developed, and when it emerged from the Great Depression, monetary
policy was seen as having little independent power to influence the economy and was just the
helpmate of the more powerful fiscal policy. The Fed’s principal method of undertaking monetary
policy, open market operations, was not even envisioned at its creation; the technique of
influencing the money supply through the sale and purchase of securities on the open market was
inadvertently discovered during the early years of its existence as the Fed attempted to manage its
portfolio of assets. For these reasons, it is not all that surprising that some observers believe that
the Fed’s structure is not well suited to its job.
The Fed’s structure has been changed several times since it was established. Its current structure,
however, is largely the same as that which emerged in the late 1930s. U.S. monetary policy is
determined within the Federal Reserve System. At the top of the system is the seven-member
Board of Governors appointed to staggered 14-year terms by the President with Senate advice and
consent. No member may be reappointed to a new term after having served a full term. By the
same appointment and approval process, a Chairman and Vice Chairman are selected from the
seven to serve four-year terms. These terms do not coincide with that of the President. The
President can remove Fed governors “for cause” before their term has ended, but not on the basis ³
of policy differences or incompatibility. In practice, the President has never done so. The
Chairman of the Fed, though considered quite powerful, has only one vote on the Board. His
power derives principally from setting the Board’s agenda, from his role as the Fed’s
representative in meetings with other government officials, and from his control of the Board’s
staff.
There are 12 regional Federal Reserve Banks, which were established in the belief that the system
should safeguard against a concentration of power in New York or Washington. Each is set up as
a private operation owned by member banks, with a nine-member Board of Directors. Six of the
Board members are selected by member banks and three by the Board of Governors, including a
chairman and deputy chairman. The Board of Directors then appoints the president and first vice ⁴
president of its regional bank, subject to Board of Governors approval.
The seven members of the Board of Governors sit with the president of the New York Federal
Reserve Bank and four other regional bank presidents, who are selected on a rotating basis among
the other 11 regional banks, on the Federal Open Market Committee (FOMC). The FOMC is
responsible for determining the target for the federal funds rate, which is the inter-bank overnight
lending rate. The target is maintained through open market operations, which is the principal tool
of monetary policy. The discount rate, which is the rate at which the Fed lends to liquidity-
constrained banks, is set by the Board alone upon application by a regional bank for a change.

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Money is placed into circulation through the purchase of U.S. Treasury securities. Because the
system holds a large portfolio of securities, it earns income. Essentially, this is income from
money creation and it is technically referred to as seigniorage. Member banks are the
shareholders of the Federal Reserve Banks, and a dividend is paid to member banks
corresponding to their stake in the system. After operating costs are deducted, and additions are
made to its capital account (to maintain solvency), the rest is remitted to the Treasury, where it is
recorded as “miscellaneous receipts.” In 2005, it was estimated that 92% of the Fed’s profits, or
$21.5 billion, was remitted to the U.S. Treasury. About 3% of its profits were paid in dividends to
shareholder banks and 5% were added to its capital.
The way in which the Fed earns and passes on income means, first, that the government receives
the revenue from money creation just as it would if, say, the Treasury administered monetary
policy instead of the Fed. It means, second, that the Fed does not need a congressional
appropriation of funds to operate. It has its own source of revenue and can conduct policy free of
concern that budgetary pressure might be applied by those wanting to influence its decisions.
Although the Fed has great latitude in implementing monetary policy, the goals that it is
mandated to achieve through monetary policy are determined by Congress. In this sense,
monetary policy is neither independent nor undemocratic. Having said that, both opponents of the
Fed’s independence and many economists would agree that the Fed’s current mandate is broad
and vague, and, therefore, greatly enhances its independence for better or for worse. Its charge
derives from the legislation that created it (Federal Reserve Act, P.L. 63-43), from which comes
its responsibility to provide an “elastic currency”; the Federal Reserve Reform Act of 1977 (P.L.
95-188), which directs it to maintain stable prices, maximum employment, moderate interest
rates, and sustainable growth; and the Full Employment and Balanced Growth Act of 1978 (P.L.
95-523), which requires it to relate its policy to the employment goals of the entire federal
government set pursuant to the aims of the Employment Act of 1946 (P.L. 79-304).
As will be shown below, these goals frequently conflict. Collectively, they amount to telling the
Fed that it is to make good economic policy. Given that these goals often cannot all be pursued
simultaneously, and that some—even by themselves—can only be sustained temporarily, the Fed
can usually find legislative authority for any monetary stance it assumes.

Many recessions occur because aggregate supply exceeds aggregate demand. In other words, total
spending is lower than what the economy is capable of producing. Economists attribute this
phenomenon to the presence of price stickiness. When the demand for goods and labor falls,
prices should fall to a point where adequate demand is restored. But because price adjustment
does not happen quickly—due to the presence of contracts, menus, and uncertainty—output
declines. This can lead to a vicious cycle where unemployment rises and resources fall idle—
lowering aggregate demand further. In the long run, prices will adjust and the economy will
return to its full potential. However, the examples of the Great Depression and the Japanese
economy in the 1990s suggest that the long run can be very long indeed.
If the government does not wish to wait for this long run self-adjustment to occur, it has two
primary tools at its disposal to boost aggregate demand. The favored tool at present is monetary
policy. The Fed can inject newly printed money into the economy by purchasing U.S. Treasuries,
a process referred to as expansionary monetary policy. Since prices do not adjust instantly, this

money will increase aggregate output if there are unused resources in the economy. The channel
through which this spending increase occurs is lower interest rates. The cost of borrowing is
lowered as the reserves available to the banking system expand. Thus, aggregate spending is
boosted through higher investment spending on capital goods, equipment, and buildings and
through higher consumption on interest-sensitive goods like automobiles, homes, and appliances.
Aggregate spending is also boosted through the foreign trade sector. Lower interest rates attract
less investment to the United States, and, other things being equal, this reduces demand for the
dollar. As the exchange rate depreciates, foreign spending on U.S. exports and the U.S. ⁵
production of import-competing goods will rise.
In the long run, the printing of money can have no real effect on the economy—sustained
inflation is a purely monetary phenomenon. Reductions in unemployment resulting from
expansionary monetary policy are either temporary (if the economy was already at full
employment when policy was changed) or would have eventually occurred anyway (if the
economy was not at full employment). Prices will adjust to the increase in the money supply,
causing inflation to rise. The closer the economy is to its full potential when monetary policy
becomes expansionary, the more the increase in aggregate demand will be transmitted into higher
inflation rather than greater output.
Another stabilization tool at the government’s disposal is fiscal policy. The government can boost
its spending and finance it through an increase in its budget deficit (or a reduction in its surplus).
This increases aggregate demand directly by increasing the government’s purchase of goods and
services. Similarly, the government can cut taxes through a smaller surplus or larger deficit,
which boosts household spending by increasing disposable income (assuming that households
spend the tax cut rather than save it). But unlike expansionary monetary policy, expansionary
fiscal policy results in rising, rather than falling, interest rates, other things being equal. Interest
rates rise because deficits are financed out of private saving. That results in the availability of less
private saving for private capital investment. The demand for investment on a smaller pool of
saving bids up the price of that saving, the interest rate. When the economy is deep in recession,
the demand for investment may be very weak, and deficit spending will cause little upward
pressure on interest rates. By contrast, if the economy is operating near full potential when
expansionary fiscal policy is undertaken, then interest rates will rise substantially, crowding out ⁶
most of the increase in aggregate demand caused by expansionary fiscal policy.
When interest rates rise, foreign investment is attracted to the country, offsetting some of the
decline in saving available for investment. However, this causes the dollar exchange rate to
appreciate, which reduces foreign demand for U.S. exports and U.S. demand for import-
competing goods. This also crowds out the boost in demand caused by expansionary fiscal policy
to the extent that it causes interest rates to rise. Thus, as the U.S. has become more open to
international capital flows and trade, monetary policy has become more powerful and fiscal
policy less powerful. That is because exchange rate effects work to reinforce the effects of
monetary policy on aggregate demand but offset the effects of fiscal policy.

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Unlike monetary policy, expansionary fiscal policy cannot lead to a sustained increase in the
inflation rate—there is some limit beyond which the deficit will stop rising, even if it remains
high. First of all, the deficit cannot exceed 100% of aggregate spending. Even before that point,
the deficit must stop growing if the public can no longer reasonably believe that government
bonds they purchase will be honored. But the money supply can keep growing as long as it is
allowed to do so. As long as some people are willing to hold money, the money supply can grow;
many historical examples of hyperinflation suggest that some people will hold money even at
extremely high monetary growth rates.
While the ability of fiscal policy to raise or lower inflation is only temporary, monetary policy
can only raise or lower (inflation-adjusted) interest rates temporarily. Using monetary expansion
to push rates down in an economy that is fully employed will just stimulate higher prices. These
higher prices will offset the initial depressing effect that expansionary monetary policy had on
interest rates since the Fed has not changed the resources available in the economy for
investment. On the other hand, fiscal policy can have a permanent effect on interest rates. A high
level of government borrowing, even if the level is constant, can hold interest rates up indefinitely
because of its effects on the saving available for investment.
Thus, in the short run both fiscal and monetary policy increase economic growth and inflation.
But expansionary fiscal policy results in higher interest rates, whereas expansionary monetary
policy results in lower interest rates. Likewise, contractionary fiscal policy lowers growth and
inflation with lower interest rates as a result, whereas contractionary monetary policy leads to
higher interest rates. In the long run, monetary and fiscal policy have very different influences,
however. Fiscal policy helps determine the interest rate, monetary policy does not. Monetary
policy determines the inflation rate, fiscal policy does not. Neither can permanently boost the
long-run economic growth rate; this is determined by the growth rate of labor, capital, and
productivity.
Obviously, not all the adjustments referred to above occur immediately. Otherwise there would be
no short run imbalances and the economy would always be at full employment. Experience
teaches that this is not the case. Historical evidence indicates that the full price effects from fiscal
and monetary policy come roughly two years after the policy is implemented. Employment
effects come much faster, within two or three quarters. The reason for this asymmetry in lags is
price stickiness. Although hard to quantify, expectations play an important role here as well. If
individuals expect inflation to accelerate or decelerate, it will do so more quickly, even if
policymakers claim to desire otherwise.
The closer the economy is to full employment when demand management is undertaken, the
faster the price effects will occur. But even in a fully employed economy, prices will not adjust
quickly enough that output effects are zero and the full rise in inflation is immediate. Growth will
be boosted, but the boom will be unsustainable and short lived. The legacy of expansionary
policy will be higher inflation. Similarly, if faced with undesirably high inflation, contractionary
policy will reduce output and increase unemployment in the short run. Only later will prices
adjust to slow inflation.
Moreover, how long it takes inflation to slow down in response to contractionary policy, and how
long higher unemployment must be endured, depend on the credibility of the central bank’s anti-

inflation plan. If the public thinks that a contractionary policy will soon be abandoned, then prices
will not be adjusted, and inflation and heightened unemployment will be slow to abate.
The role of credibility, expectations, and the state of the economy all result in variability in the
length of the policy lag and the magnitude of the output response. Thus, it is difficult to design a
policy with any precision that can systematically counteract the various pressures, which
themselves are often poorly understood, that tend to generate swings in economic activity. This
means not only is it impossible to calibrate policy well enough to avoid business cycles, but that
attempts to do so may even make the cycles worse. In hindsight, some economists have blamed
many recessions on monetary policy errors.

Criticisms of the Fed’s structure break down to three notions. First, some believe the Fed is too
independent in the sense that its decisions are too far removed from the will of the public.
Second, critics say that monetary and fiscal policy are made in isolation from each other, so that
there is no mechanism to guarantee their coordination. Third, others argue that as an institution,
the Fed is insufficiently open or accountable, with its activities shrouded in secrecy and with little
external supervision or examination of its outlays, management practice, and policy decisions.
In general, both those who argue for continued broad discretion and those who argue for change
emphasize the importance of monetary policy for the economy and make it the center of their
arguments. Basically, one side maintains that monetary policy is too important to be put into the
hands of a few appointed officials. The other believes that it is too important not to do so.
While monetary policy is important, one must keep in mind how it is important. The short-run
effects of monetary policy differ substantially from its long-run effects. Whatever argument is
advanced to support or attack independence, it should not be predicated on the belief that the
Fed’s job is to control interest rates. The Fed’s influence over the economy is short-term only. In
the long run the Fed does not control real interest rates, and efforts aimed at controlling interest
rates based on its short-run influence generally result in accelerating inflation or deflation.
Whereas fiscal policy is made jointly by the legislative and executive branches, monetary policy
is influenced only indirectly by either. The long terms of Fed governors, the fact that they are
appointed rather than elected, and the fact that the institution has its own source of funding means
that Fed governors and other FOMC members are likely to be less responsive to swings in public
opinion than are the makers of fiscal policy.
This does not automatically mean that the structure of the Fed is inconsistent with the traditional
character of American government. For example, members of the federal judicial branch are
appointed, in their case for life, and there is a constitutional prohibition on diminishing their
salary while in office. It should again be stressed that the overarching goals of monetary policy
are determined by Congress; it is merely the day-to-day implementation of those goals that has
been delegated to an independent Fed. What makes monetary policy unusual is the fact that it is
not implemented by the executive branch, whose chief is directly elected but is otherwise staffed
by civil servants and appointees serving at the discretion of the chief. Thus, at issue is not

whether the Fed’s independence is unique in our government—it is not—but whether its
independence is appropriate or advantageous for the conduct of monetary policy.
Several elements of the earlier analysis bear on this issue. First, there is the difference in the
short-run and long-run effects of monetary policy. The positive employment effects from an over-
expansion of the money supply are temporary and experienced in the short run. The higher rate of
inflation comes later—it would not even begin to be felt for a year or two, the length of a ⁷
congressional term. The economic costs of high and variable inflation are well chronicled.
Similarly, anti-inflation policy takes a long time to achieve its results; in the interim it causes an
increase in unemployment. If elected officials seek short-term “gain” at the cost of long-term
“pain,” this lag structure would impart an inherent bias toward inflation. It would also tend 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.
By insulating decision-makers from the immediate effects of public pressure, proponents point
out that independence may help offset that bias. The Fed may be better able than other institutions
to resist the temptation to “gun” the economy in preparation for an election. Similarly, when
attempting to reduce entrenched inflation, the Fed may more easily “tough out” criticism of a
contractionary policy until inflation abates, thereby avoiding a premature policy reversal that
renders the already-incurred unemployment costs pointless.
This argument in favor of independence is necessarily not one for total insulation of decision
making. In fact, total insulation probably does not exist: many Fed critics believe there are many
historical examples that suggest that political pressure led to incorrect decisions by the Fed. What
it might suggest is putting monetary policy on a “slow fuse,” where outside judgement operates
over a longer time horizon. Even then, the economic advantage of independence would have to be
weighed against a number of non-economic factors favoring less independence.
Some proposals for change stop short of eliminating Fed independence. Whether it is worthwhile
to decrease the Fed’s independence by placing officials from the executive branch on the Board of
Governors, or by subjecting the Fed’s budget to congressional approval, is a matter of judgement
of both a democratic and economic nature. But the economics of monetary policy is such that the
cost of making the Fed more responsive to short-term public opinion would likely be an increased
tendency to inflate the economy and to reverse anti-inflation policies before they have time to
achieve their intended purpose. International evidence backs up this theory, at least when
independence is broadly defined, since many central banks that do not enjoy a level of ⁸
independence similar to the Fed have allowed higher inflation on average.
The second element of independence, credibility, reinforces the first economic argument. In the
short run, the responsiveness of inflation to changes in monetary policy depends in part on
people’s expectations of the Fed’s behavior. Imagine that the Fed were to tighten monetary policy
to reduce an uncomfortably high inflation rate. If people believed that the Fed would be unwilling
to follow through with an anti-inflationary stance once unemployment rose, then people would
reduce their inflationary expectations very slowly and cautiously. This would feed through into
wage contracts and pricing decisions by firms that would cause inflation to be temporarily higher

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than expected given the change in monetary policy. Since it is sluggish price adjustment that
causes unemployment to rise and output to contract in the short run, this suggests that the rise in
unemployment caused by the contractionary policy would be greater and more persistent than if
the central bank had greater credibility. Thus, even when a less independent central bank is
resolved to pursue an anti-inflationary policy to its end, its lack of independence may lower its
credibility, making the policy more painful and persistent in the short run than it otherwise would
be.
Third, the alternative to an independent central bank has implications for the checks and balances
of our government. Legislative bodies are not designed to administer policy; Congress could not
fulfill the Fed’s current task of setting discretionary policy on a day-to-day basis. Thus, Congress
would have two choices: eliminate discretion through the adoption of a rule, an option considered
below, or delegate the day-to-day administration of discretionary monetary policy to the
administrative branch. The latter would tilt economic power significantly toward the executive.
The checks and balances applicable to fiscal policy would not apply to monetary policy. Thus,
eliminating the Fed’s independence would not simply make the federal government more
democratic; it would also have implications for the checks and balances of power that some might
see as making the government less democratic.
To judge how important the economic benefits of Fed independence may be, it is useful to
consider the example of fiscal policy. Like monetary policy, expansionary fiscal policy has short-
run benefits, in terms of higher output and employment, and long-term costs, in terms of higher
inflation and debt burdens. Perhaps the overwhelming reason why fiscal policy has fallen into
disrepute with many economists as a stabilization tool is precisely because of the unwillingness of
elected lawmakers to tighten fiscal policy (reduce a budget deficit) when aggregate demand is ⁹
“overheating.” A rule of thumb for effective fiscal policy is that the budget should be balanced
over the business cycle—budget deficits in recession years should be offset by surpluses in boom
years. In practice, the federal budget was in deficit in 36 of 37 years between 1961and 1997, and
returned to deficit in 2002 after four years of surplus.
Some observers consider coordination an important element of Fed reform because under the
current system monetary and fiscal policy are made separately. While coordination may take
place, the Fed is free to follow a policy totally at odds with the fiscal stance taken by Congress
and the President. It is entirely possible for monetary policy to be undoing what fiscal policy is
doing with output and employment, or for monetary policy to be reinforcing the effect that fiscal
policy is having on interest rates. Directed in concert, the two policies should be able to produce
much more effective policy than if they are determined in isolation of each other.
In particular, using fiscal and monetary policy in concert allows aggregate demand to be
influenced with minimal disruption to interest rates and the exchange rate, since fiscal policy
pushes interest rates and the exchange rate in the opposite direction of monetary policy. This has
several advantages. For example, if resources cannot be reallocated completely fluidly and
costlessly, it may minimize the difference in output effects on particular sectors or regions of the

⁹^O^t^he^r^r^e^a^s^ons^w^h^y^m^one^ta^r^y^policy^is^pr^e^f^e^r^r^e^{d by}^e^c^onom^is^ts^inc^l^ude^t^h^e^f^a^c^t^tha^t^the^Fe^d’^s^s^t^a^f^f^is^m^o^r^e^s^p^e^cⁱ^a^lize^d^,
^t^h^{e f}^act^t^h^at^m^oⁿ^e^t^a^r^y^p^o^lⁱ^c^y^c^aⁿ^b^e^al^t^e^red^m^o^{re q}^uⁱ^ckl^y^b^ecau^{se i}^t^d^o^e^sⁿ^o^t^go^t^h^r^o^u^{gh t}^h^e^l^e^gi^sl^atⁱ^v^{e p}^r^o^cess,^an^d
^b^ecau^{se o}^f^exch^an^g^e^rat^e^an^dⁱⁿ^t^e^rest^rat^e^b^eⁿ^e^fⁱ^t^s^t^o^u^sⁱⁿ^{g m}^oⁿ^e^t^a^ry^p^o^lⁱ^c^y^rat^h^{er t}^h^an^fⁱ^scal^p^o^lⁱ^c^y^.

economy in the short run. It may also prevent economic imbalances from forming or mitigate
existing imbalances in the short run. Furthermore, it may make long-term business planning more
predictable, since such planning is highly dependent on interest rates and exchange rates.
However, if fiscal and monetary policy were coordinated, they could also produce much worse
policy. Just as a well-conceived fiscal policy can be enhanced by monetary policy designed to
support it, an ill-conceived fiscal policy can become all that more damaging to the economy if
reinforced by a monetary policy made to go with it. Hence, good policy can be much better if
monetary and fiscal policy are coordinated, but bad policy can be made much worse.
The potential for ill-conceived coordination is particularly great due to the relative roles of the
two policies in affecting interest rates and inflation. Large fiscal deficits frequently arise from a
deadlock concerning whether to raise taxes or reduce spending. These deficits tend to hold
interest rates higher than they would be otherwise. In systems amenable to coordination, the
temptation thereby arises to use expansionary monetary policy to lower interest rates that have
been forced up by fiscal policy. Since interest rates are not something that monetary policy can
influence in the long run, the result is accelerating inflation, an outcome that large deficits could
not achieve on their own.
In this regard, it is worth noting that studies of hyperinflations have consistently identified two
essential components of the policies that ultimately brought such episodes to an end; one of them ¹⁰
is an independent central bank capable of refusing a government’s requests for money. Clearly,
coordination has not always proven a recipe for sound demand management policy.
The fiscal situation of the government in the 1980s and early 1990s illustrates the dilemma well.
Large budget deficits tended to keep interest rates high, and relatively little progress was made in
bringing deficits down until the late 1990s. Had the Fed been under the control or influence of the
Administration or Congress, they would have had the option of “coordinating” this fiscal policy
with more expansionary monetary policy as a solution to the problem of high interest rate effects.
Since such policy is short-run in its effect, the effort to coordinate policy in this way would be
inflationary.
This observation does not imply that coordination is undesirable. Rather, it highlights the cost of
coordination: the risk of putting all policy eggs in one basket. The current division of economic
policy responsibilities, therefore, produces yet another check-and-balance arrangement. Because
of this split in responsibilities, no stabilization policy is likely to be carried very far in one
direction unless consensus is achieved among different policymaking bodies.
Proposals to better coordinate monetary and fiscal policy, including placing monetary policy
under the control of the Treasury, putting a Treasury official on the Board of Governors, and
matching the term of the Fed chairman with that of the President, raise this balance-of-power
dilemma. Opting for more or less coordination therefore boils down to a trade-off between
maximizing the benefits that come from policy when it is well-chosen and minimizing the costs
that occur when policy is ill-advised.

¹⁰^F^o^{r exam}^p^l^e,^see^T^h^o^m^{as S}^a^r^g^en^t^,^“T^h^e^Eⁿ^d^s^o^f^F^o^u^r^Bi^{g In}^f^l^atⁱ^o^ns,^”ⁱⁿ^R.^Hal^l^,^ed^.^,^Iⁿ^f^l^ati^on:^C^a^us^e^s^and^Effe^c^t^s
⁽^U^niv^e^r^s^it^y^of^C^h^ic^a^g^{o P}^r^e^s^s^,¹⁹⁸²⁾^.

The third area of concern to critics of the Fed’s independence is the secrecy with which
operations at the Fed are conducted. Transcripts of the FOMC’s deliberations are not released for
five years, and minutes of FOMC meetings are released only after the following FOMC meeting.
The Board is audited by outside auditors. (Board staff audit the regional Fed banks.) The
Government Accountability Office (GAO), already the auditor of a variety of sensitive
government agencies and regulatory bodies, is limited in what kinds of audits it can conduct of
the Fed. It is specifically prohibited from auditing the Fed’s monetary policy activities.
The issue of accountability should be viewed as distinct from the issue of democracy.
Democracy—in this case, the potential shifting of the powers of the Fed to elected officials—is
one approach to increasing accountability, but it is not the only one. The next section considers an
alternative method of increasing accountability, the use of rules. Hence, some may advocate
greater Fed accountability without favoring diminished Fed independence.
There is little that economic analysis can contribute to this area of debate. Policy may be better or
worse under greater public scrutiny, and whether it is or not must be judged in terms of what best
makes for “good government.” Accountability could have two economic effects worth exploring.
First, what costs does secrecy impose on markets? Second, how would greater disclosure affect
the Fed’s behavior and Congress’s oversight abilities?
Fed-watching engages real resources, albeit small in comparison to the overall economy, in the
task of second-guessing monetary policy. In addition, costs may be imposed by market
fluctuations caused by unfounded speculation over Fed policy. The rational expectations literature
stresses the importance of information about both the present and the future in making efficient
decisions. If the Fed’s secrecy creates needless uncertainty, economic efficiency and welfare
could be reduced. Presumably, if more information on Fed deliberations were available to the
public these costs could be reduced.
The need to out-guess the Fed, however, does not so much result from Fed secrecy as much as
from the use of discretion in monetary policymaking. The advantage in any market is in
predicting events before someone else does; this is true whether market agents are trying to figure
out what Fed policy is or what it will be. And as long as discretion is employed, there are limits
on just how much policy can be spelled out in advance. Thus, proposals to increase disclosure
(e.g., through immediate release of FOMC minutes or official statements concerning the Fed’s
intermediate targets) might not do much to diminish Fed-watching. Nor would a reduction in
independence diminish Fed-watching if the new policy regime were based on discretion.
However, more complete disclosure might have a different benefit. It might produce better policy.
The fact that the Fed can make pronouncements about policy in vague, qualitative terms allows
the potential for policy to be made in an ad hoc or idiosyncratic way. Whether it does so in fact is
not clear—indeed, it is impossible to judge objectively given that its pronouncements are vague.
The members of the FOMC may have very definite models of economic behavior in mind when
deciding whether to tighten or loosen policy. Whatever those models are, however, they are not
always clear to outside observers.
Proponents of more complete disclosure believe it could promote more closely reasoned decisions
about policy that reflect just what economic events are considered by the FOMC to be indicative
of a certain policy, why that policy follows logically from those events, and what future events

would be accepted as evidence that the policy is no longer appropriate. This view holds that fuller
disclosure would force the Fed to specify its picture of the economy and thereby help ensure that
one actually exists.
Better accounting of the Fed’s actions could also help Congress in its oversight of Fed
performance. Congress has the Congressional Budget Office (CBO) and the Joint Committee on
Taxation to help provide independent evaluation of fiscal and tax policy. But it must depend on
the Fed itself in assessing monetary policy much more than it does on the Treasury or Office of
Management and Budget (OMB) in tax and budgetary matters. Independent evaluation of the
Fed’s actions on a periodic basis could put Congress in a position more analogous to that it is in ¹¹
when studying fiscal and tax policy.
Other economists would argue that there is a limit to achieving adequate disclosure and oversight
as long as the Fed explains its decisions qualitatively rather than quantitatively. For example,
when reading the Fed’s policy statements, some Fed watchers claim that the Fed’s view of the
potency of monetary policy—and hence personal culpability—sharply declines whenever there is
an economic downturn. Ultimately, they argue, only rules that link hard data to policy decisions
can be judged objectively.
Critics of Fed independence cannot complain that the goals of monetary policy have been
determined in an undemocratic fashion: the goals of the Federal Reserve are mandated by
Congress. To a great extent, if the Fed’s policymaking is vague and unaccountable, it is because
Congress has given it a vague and oftentimes internally inconsistent mandate. Rather, opposition
to Fed independence lies with the fact that unelected officials have considerable discretion in
pursuing that mandate, and the fact that voters and elected representatives have limited
institutional oversight to ensure that the Fed fulfills its mandate.
Since the economics of independence suggest considerable economic disadvantages would arise
from shifting discretion to elected officials, most economists concerned with the status quo have
focused instead on devising ways to remove discretion from monetary policy. Their efforts have
focused on strengthening the Fed’s mandate such that it ceases to be a fuzzy guideline and instead
becomes a strict rule. With a precise enough rule, decision-making by the Fed would be largely
unnecessary, and accountability would be straightforward. “Fed watching” would be unnecessary
as markets would never need to second-guess what motivated policy decisions and what decisions
would follow a change in economic conditions. Policy would change predictably and
automatically as economic data became available.
The drawback to a rule-based policy regime lies in the fact that the Fed does not precisely or
directly control the variables with which it is most concerned—notably, inflation or the growth
rate of aggregate demand. Its interest rate decisions influence these variables, but imprecisely,
variably, and with long lags in their effectiveness. Thus, rules based on the variables of ultimate
concern cannot be applied in a straightforward and easily verifiable fashion. Alternatively, the

¹¹^Ev^a^l^ua^tions^{in t}^h^is^c^o^nte^x^{t s}^h^o^u^l^d^be^dis^ting^uⁱ^s^h^e^d^f^r^om^a^udit^po^w^e^r^s^pr^op^os^e^d^f^o^r^G^A^O^{in s}^o^m^e^pr^o^pos^a^l^s^.^Uⁿ^lⁱ^k^e
^the^e^c^oⁿ^o^mⁱ^c^aⁿ^a^l^y^s^is^pe^r^f^or^m^e^{d by}^s^{upport a}^g^eⁿ^cⁱ^e^s^s^u^c^h^a^s^CBO^{or t}^h^e^J^oⁱⁿ^{t T}^a^x^Com^m^ittee^,^a^udi^ts^of^the^ty^pe
^c^ond^uc^te^d^by^G^A^O^a^r^e^e^s^s^e^ntia^lly^c^h^e^c^k^s^o^f^a^c^c^ounting^aⁿ^{d m}^a^nag^e^m^e^{nt pr}^oc^e^dur^e^s^{. T}^hus^{, g}^r^aⁿ^tiⁿ^g^of^br^oa^de^r^a^u^d^it
^pow^e^r^s^w^ould^no^{t be}^e^x^pe^c^t^e^d^t^o^g^e^ne^r^a^te^inde^pe^nde^{nt e}^c^oⁿ^o^mⁱ^c^ev^a^l^ua^tions^of^Fe^{d m}^one^ta^r^y^polic^y^.

variables that the Fed can control are not variables that influence society’s economic welfare in
and of themselves. A rule could direct the Fed to cause the money supply to grow at a certain rate,
to fix short term interest rates at a certain level, to fix the exchange rate value of the dollar, or to
keep the price of gold constant. But none of these rules would be directly related to economic
stability. Targeting the growth rate of the money supply or the price of gold would not deliver
economic stability because neither are predictably or systematically related to economic growth
or inflation. Fixing interest rates would not provide economic stability because the Fed only
controls the supply of short-term credit. Variability in the demand for credit means that different
interest rates are appropriate at different times. Fixing the exchange rate may increase external
stability, but is unrelated to internal stability. The other drawback to a rule is that since the Fed
has only one tool, it can potentially target only one variable with any precision. But it is
concerned with at least two variables, inflation and the growth of aggregate demand. More goals
dilute the effect that its policy tool has on each particular goal.
This difference between policy goals and the policy tools available explains why discretion exists
in the first place. If there were a simple relationship between the Fed’s actions and their effect on
inflation and unemployment, the Fed would not need to use its discretion in determining the
proper policy. The minority of economists who see the Fed itself as the primary cause of ^th
economic instability in the 20 century would argue that any strict rule, regardless of how directly
related to inflation and demand growth, would lead to greater economic stability than
discretionary policy. But most economists accept that economic stability rests upon the use of
monetary policy to stabilize inflation and demand growth. Those who accept this but oppose
discretion have endorsed the “Taylor rule,” developed by economist John Taylor, now
Undersecretary of the Treasury. Under a Taylor rule, the Fed would automatically alter interest
rates based on a simple equation that responds to changes in inflation and output growth.
Detractors of this and other rules stress that interest rate changes do not always influence the
economy predictably, uniformly, or promptly; thus, the use of a rule could potentially be ¹²
destabilizing, particularly in times of crisis.
Between the polar alternatives of complete discretion and strict rules lies a spectrum of looser
rules that would reduce but not eliminate the Fed’s discretion. The most famous of these is an
inflation target, which has been adopted by several foreign central banks, including the European ¹³
Central Bank and the Bank of England. An inflation target would mandate that the sole goal of
monetary policy is to keep the inflation rate equal to a predetermined rate (or within a
predetermined band) in the long run. But unlike a strict rule, central bankers would remain free to
use their discretion to reach their target. If this rule were strictly interpreted, it would be quite
strict indeed—even small increases in inflation would lead to sharp increases in interest rates
under any circumstances, and vice versa. But it could be destabilizing since demand growth
would be neglected entirely. For instance, an oil shock could simultaneously cause a recession
and an acceleration in the inflation rate. A strict inflation target would require the central bank to
raise interest rates, worsening the recession. In practice, foreign central banks have proven quite
responsive to changes in demand growth, even when inflation is above its target. And their
mandate has typically included many caveats and exemptions to ensure flexibility. This raises the

¹²^For^m^o^r^e^inf^o^r^m^a^{tion o}ⁿ^m^one^ta^r^y^policy^r^u^le^s^,^s^e^e^C^R^S^R^e^por^{t R}^L³¹⁰⁵^0,^F^o^r^m^ul^atioⁿ^{of M}^o^ne^tar^y^Polic^y^by^t^h^e
^Fed^e^ra^{l Reserve: Ru}^{les vs.}^Discre^tioⁿ^{, by}^Ma^r^c^L^a^bonte^.
¹³^For^m^o^r^e^inf^o^r^m^a^{tion, s}^e^e^C^R^S^R^e^por^t^98-^16,^S^h^o^u^ld^the^Fe^de^r^a^l^Re^s^e^r^v^e^Adopt^{an I}ⁿ^fl^ati^on^Tar^g^e^t^?^{, by}^Ma^rc
^L^a^bonte^a^{nd G}^a^{il E.}^Ma^kⁱ^ne^{n a}ⁿ^d^C^R^S^R^e^por^{t R}^L³¹⁷⁰²^,^Pric^e^St^a^b^ility⁽^I^nfla^tio^{n T}^a^rge^tⁱ^ng)^{as t}^h^e^Sole^Go^al^of
^Moⁿ^e^t^a^{ry P}^o^lⁱ^{cy: T}^h^{e I}ⁿ^t^e^rn^a^tⁱ^ona^l^E^x^p^e^ri^en^ce^,^by^Ma^r^c^La^bonte^a^{nd G}^a^{il E. Ma}^kⁱ^neⁿ

criticism that inflation targets have not meaningfully reduced discretion—central bankers are still
free to do as they see fit.
Viewed objectively, an inflation target strikes a balance between rules and discretion, and enjoys
some of the benefits but suffers from some of the drawbacks of both. Under an inflation target, it ¹⁴
seems unlikely that inflation would be allowed to get out of hand for long without ramifications.
Central bankers could no longer justify any policy stance by pointing to conflicting parts of their
mandate. In this way, accountability would be increased. On the other hand, an inflation target as
practiced still lacks a quantifiable way to evaluate specific discretionary decisions. As economists
Ben Bernanke and Frederic Mishkin (now Chairman and Governor of the Federal Reserve,
respectively) argue, “constrained discretion” is probably a more apt description of the ¹⁵
international experience with inflation targets.
Would a rule-based monetary policy be a more democratic arrangement than discretionary control
by unelected officials? The answer to that question is beyond the scope of this report. Economist
Milton Friedman, for one, believed it would be more democratic. In Friedman’s eyes, the contrast
between rules and discretion in monetary policy was analogous to the contrast between the Bill of
Rights and leaving decisions of individual liberty in the hands of the legislature. He reasoned
satirically,
^W^h^yⁿ^o^{t ta}^k^e^u^p^{each (f}^ree^s^p^eech^{) cas}^e^s^e^paratel^y^aⁿ^{d treat}ⁱ^t^on^it^s^o^wⁿ^m^e^rits^?^Is^t^h^isⁿ^o^t
^th^{e co}^uⁿ^ter^p^ar^{t to}^th^{e u}^s^u^a^{l ar}^g^u^m^eⁿ^{t i}ⁿ^m^oⁿ^e^tar^y^p^o^lic^y^th^a^t^{it is}^uⁿ^d^e^sⁱ^r^a^b^l^e^t^o^tⁱ^e^t^h^e^h^aⁿ^d^s
^of^th^e^m^oⁿ^e^tar^y^auth^orit^yⁱⁿ^adv^aⁿ^{ce; t}^h^{at it s}^h^ou^{ld be lef}^t^f^r^e^e^{to treat each}^c^a^s^e^oⁿⁱ^t^s^m^e^rⁱ^ts¹⁶
^as^{it co}^m^e^s^u^p^?^W^h^yⁱ^sⁿ^o^{t t}^h^e^arg^u^m^e^{nt equ}^a^ll^y^v^a^lid^f^o^{r s}^p^eech^?

An argument against independence cannot be predicated on the belief that interest rates can be
fixed or that inflation and recession could always be avoided if interest rates were never raised.
Instead, an economically valid argument against independence can be made as long as it
recognizes that the positive effects interest rate reductions have on output and employment come
sooner than the negative effects interest rate reductions have on inflation. Similarly, anti-inflation
policies bring short-term pain and only long-term rewards.
In such circumstances, independence, or partially insulating the Fed from short-term political
pressures through institutional arrangements, is a way to make painful but necessary policies
more likely to occur. There are also some possible economic drawbacks to independence that
merit consideration. First, oversight is difficult in the current system, and this makes it difficult to
prevent or reverse poor policy decisions by the Fed. Second, potential benefits of coordinating
monetary and fiscal policy cannot be secured. While disallowing coordination means that the
benefits of good policy cannot be maximized, it also means that the effects of bad policy can
potentially be minimized.

¹⁴^In^t^hⁱ^s^veiⁿ^,^t^h^{e recen}^t^Jap^aⁿ^e^se^exp^e^ri^en^{ce o}^f^p^r^o^l^oⁿ^g^ed^d^e^f^l^atⁱ^o^{n su}^ggest^{s t}^h^at^anⁱⁿ^f^l^atⁱ^o^{n t}^a^rget^sh^o^u^l^d^al^s^o^h^a^{ve a}
^low^e^r^boun^da^r^y^{to pr}^e^v^eⁿ^{t the}^pe^r^s^is^te^nc^e^of^poor^po^lic^y^{in the}^ot^he^r^dir^e^c^tio^n.
¹⁵^B^e^{n B}^e^rⁿ^aⁿ^k^e^a^nd^Fr^e^d^e^r^ic^Mis^h^kⁱ^{n, “}^I^nf^la^{tion T}^a^r^g^e^ting^:^A^N^e^w^Fr^a^m^ew^or^k^f^o^r^Mone^ta^r^y^P^o^lic^y^?^”^J^our^na^{l o}^f
^Ec^onom^ic^Pe^r^s^p^e^c^tiv^e^s^{, v}^o^{l. 11}^{, n}^o^{. 2}^,^s^p^ri^ng¹⁹⁹⁷^,^p.¹⁰^6.
¹⁶^Milt^on^Fr^ie^dm^aⁿ^{, “}^A^{n I}^nde^peⁿ^d^eⁿ^{t M}^one^ta^r^y^A^u^thor^ity^,”^{in L}^e^la^{nd Y}^e^a^g^e^r^{, e}^d^.,^Iⁿ^Se^ar^c^h^of^A^M^o^ne^tar^y
^C^ons^tit^uti^oⁿ^(Ca^m^bridg^e^{: Ha}^rv^a^r^{d Univ}^e^r^sity^P^r^e^{ss, 19}⁶²⁾^{, p}^.²⁴⁰^.

If reducing or eliminating Fed independence were deemed too economically costly, are there
alternative reforms that could be considered to address the issues that critics have raised?
Monetary policy rules are another way to make policy immune from detrimental short term
pressures, and they do not suffer from some of the drawbacks of independence. Rules would also
boost accountability and some might view them as more democratic in the sense that they reduce
the discretionary power of unelected officials. The economic tradeoff between rules and
discretion is of a different nature. It boils down to a question of how well a highly complex
economy can be stabilized by a blunt and simple rule. Economists are highly divided on this
point. Many of those who support rules do so because they have little faith in the ability of the
FOMC to make better discretionary decisions than a simple rule.
An inflation target, as it has been practiced abroad, is a modest middle path between strict policy
rules and unlimited discretion, but only because it has not been implemented too literally.
Congressional oversight suffers from having the Fed’s goals as vaguely defined as they are at
present. An inflation target would tighten those goals and increase accountability if persistently
egregious policy errors were made. It would not, however, significantly reduce the Fed’s
independence as it attempted to devise discretionary monetary policy for a highly complex and
changing economy.
The economic arguments for and against Fed independence evaluated in this report apply only to
the Fed’s monetary policy responsibilities. Arguments for and against reassigning the Fed’s other
duties, such as bank regulation, to a less independent entity are beyond the scope of this report.
^{Marc L}^a^bon^t^e
^Specialis^{t i}ⁿ^Macroecon^o^mⁱ^c^P^o^licy
^m^l^abon^t^e^@^c^rs^.l^oc.g^o^v^{, 7-}⁰⁶⁴⁰