key: cord-0706645-wult0scm authors: Jordan, Jerry L.; Luther, William J. title: Central Bank Independence and the Federal Reserve's New Operating Regime date: 2020-10-14 journal: Q Rev Econ Finance DOI: 10.1016/j.qref.2020.10.006 sha: abb04929beb42983e2a1d39fd4cb863b2274f0d3 doc_id: 706645 cord_uid: wult0scm The Federal Reserve is exposed to a greater degree of political influence under its new operating regime. We survey the relevant literature and describe the Fed's new operating regime. Then we explain how the regime change reduced de facto central bank independence. In brief, the regime change increased the appointment power of the President and improved the bargaining power of Congress. We offer some suggestions for bolstering de facto independence at the Fed. In just four years, President Trump had the ability to make no fewer than five appointments to the Federal Reserve's seven-member Board of Governors. Political gridlock prevented the previous administration from filling two vacancies. The resignations of Daniel Tarrulo in April 2017 and Stanley Fischer in October 2017 created two more. Janet Yellen's decision to resign, following her replacement as Chair by Jerome Powell in February 2018, opened a fifth spot. With so many appointments available, some expressed concern that the President might reshape the Fed to his advantage-reviving old questions about central bank independence in the process. 1 While the Fed is nominally independent (i.e., it is not an agency of the federal executive departments nor the Executive Office of the President), it is nonetheless subject to political pressure. 2 The appointment process provides one channel through which monetary policy might be influenced. At least since Cukierman (1992) , most economists have recognized the importance of central bank independence for safeguarding monetary policy from short-term political pressure. 4 But one must be careful not to confuse the desirable with the factual. 5 The Federal Reserve is not immune to political pressure (Binder and Spindel 2019) . Indeed, it is less independent than most other central banks. Dincer and Eichengreen (2014) present four indices of central bank independence for eighty-nine countries in 2010. 6 Depending on the measure employed, the United States ranked 82 nd (tie), 83 rd (tie), 84 th (tie), or 87 th . Garriga (2016) offers two additional measures of central bank independence. Out of one hundred seventy-nine countries observed in 2012, 4 Earlier works include Bade and Parkin (1982) , Alesina (1988 Alesina ( , 1989 , Grilli et al. (1991) . Parkin (2013) provides a recent summary and assessment. McCallum (1997) offers an alternative view. 5 Conti-Brown (2017) questions the desirability of independence on the grounds that Fed decision makers should be accountable to democratically-elected officials. White (2010) , in contrast, argues that the "rule of law in monetary institutions is served neither by following the legislature's discretion nor the central bankers' discretion. [...] The key to stability is not the independence," he writes, "but the restraint of central bank money and credit creation." 6 Two of the four indices are constructed along the lines of Cukierman (1992 Anecdotal evidence serves to illustrate the potential for political influence at the Fed. 7 It is widely accepted that an incumbent President's odds of reelection suffer when the unemployment rate is high (Abrams 1980 , Erikson 1989 , Alesina et al. 1993 , Abrams and Butkiewicz 1995 , Fair 1996 , Blomberg and Hess 2003 Salter and Luther (2019) consider the effects of this selection mechanism. 12 It seems reasonable to think the Chair and Vice Chair are more important than other positions on the Board. They are more likely to set the agenda or establish a focal point in policy meetings and their public statements appear to carry more weight. Indeed, Kane (1988) limits his attention to the Chair in considering the President's appointment decision. See also: Beck (1987) How important is the appointment process? The BOG accounts for seven of the twelve votes cast in Federal Open Market Committee (FOMC) meetings, where the federal funds rate target is chosen. 13 Puckett (1984) shows that Governors dissent in predictable ways given the party of the President who appointed them. 14 Abrams and Iossifov (2006) find that Fed policy is more likely to be expansionary in the seven quarters prior to an election if the Fed Chair was appointed by the incumbent President's party. Perhaps this explains why, in the last fifty years, no President has failed to reappoint a Fed Chair appointed by a President of his own party. 15 Short-term politics might also influence monetary policy through a second channel, which results from congressional oversight. 16 The Federal Reserve was created by an act of Congress. Congress might amend that act to provide for policy audits or otherwise limit the Fed's discretionary powers. 17 At the very least, the Fed Chair might be harangued by members of the Committee 13 Other members include the President of the Federal Reserve Bank of New York and four of the remaining regional Reserve Bank Presidents. 14 According to Chappell et al. (1993) the appointments process-rather than direct pressure from the President-is the primary mechanism through which partisan differences in monetary policies arise. 15 Given his initial appointment by President Obama, Jerome Powell's elevation to Chair by President Trump might seem to conflict with this view. However, it is widely believed that Powell was initially appointed as part of a compromise whereby Senate Republicans got Powell on the Board in exchange for confirming Jeremy Stein, whose nomination had previously been filibustered. 16 As is widely appreciated in the political science literature, oversight might take the form direct examination (police-patrol) or indirect processes and procedures (fire-alarm). See: McCubbins and Schwartz (1984) , Lupia and McCubbins (1994) , Balla and Deering (2013) . 17 Indeed, the Federal Reserve Act has been amended many times. For example, Section 217 of Public Law No: 115-174, passed in May 2018, lowered the maximum allowable amount of surplus funds of the Federal Reserve banks. on Banking, Housing, and Urban Affairs of the Senate or the Committee on Financial Services to the House of Representatives while giving oral testimony regarding the semi-annual Monetary Policy Report to the Congress. Although one might hope members of Congress would use these powers to ensure Fed officials act in the best interest of society, they might just as easily use these powers for their own, short-term political benefit. The interaction between Fed and Congress has traditionally been considered in the context of budgetary policy (Shughart and Tollison 1983, Toma 1982) . 18 In brief, the Fed must decide how much of its revenues to spend and how much to remit to the Treasury in an environment where monitoring is costly. If it remits too much, it forgoes additional personnel and other amenities that would improve working conditions at the Fed. If it remits too little, it risks losing the discretion that enables it to make such decisions in the future. Hence, the Fed's objective function is constrained by congressional oversight. Much the same could be said about the Fed's monetary policy decisions. Fed officials presumably have some preferred course of action in mind. And Congress incurs some cost-perhaps a reduction in political capital-when it chooses to punish the Fed. If the Fed defers to Congress in setting monetary policy, it risks ending up with what it considers to be worse policies. If it deviates too far from the course of action preferred by Congress, it risks losing the discretion that enables it to make such decisions in the future. Along 18 See also: Boyd (1984) , Strong (1984) , Allen et al. (1988) . J o u r n a l P r e -p r o o f these lines, Hess and Shelton (2016) find that the Fed adjusted monetary policy in response to bills credibly threatening its power. Likewise, Grier (1991 Grier ( , 1996 finds that monetary policy is affected by the leadership on the relevant congressional oversight committees. Most economists agree that the Fed conducts monetary policy reasonably well. They also maintain that an independent central bank, insulated from short-term political pressure, is more likely to implement desirable policies. It is, therefore, easy to understand their tendency to assume the Fed enjoys a high degree of independence-a tendency regularly reinforced by official Fed statements (Selgin 2014) . In contrast, we agree with Cargill and O'Driscoll (2013) In October 2008, the Federal Reserve moved from a corridor system to a floor system. A floor system prevails when the Fed sets the FFR at or below IOR. Although open market operations might still be used to increase or decrease the supply of reserves, the supply of reserves no longer affects the EFFR. 19 The logic is straightforward. If a financial institution earns at least as much by holding reserves at the Fed as it would by lending those reserves to another institution, it will opt to hold any amount of reserves available. Open market operations will change the quantity of reserves institutions hold, but not the EFFR, since no institution lends any of the federal funds they acquire. In a floor system, the Fed influences the EFFR-or, more precisely, the unobserved bids and asks in the federal funds market-by adjusting the It is worth considering, if only briefly, why the Fed changed its operating regime. 21 In an effort to prevent the financial system from collapsing, the Fed increased its lending to financial institutions beginning in January 2008. 19 More precisely, Ennis (2018) shows that changes in the supply of reserves do not yield the traditional response in a floor system unless the quantity of reserves is large enough to make capital constraints binding. 20 Technically, the new operating regime is a leaky floor system. Since some institutions, like government sponsored enterprises, are ineligible for IOR payments, they lend federal funds to eligible institutions at a rate below IOR in an act of arbitrage. The Fed sets a rate on overnight reverse repurchase agreements to create a subfloor in the federal funds market (Williamson 2016). 21 For a more complete account, see Selgin (2018) . J o u r n a l P r e -p r o o f In July 2008, it also increased its lending to key credit markets. On its own, such lending would cause the Fed's balance sheet to grow and, in time, the price level to rise. However, the Fed offset this lending by selling Treasuries, thereby keeping a lid on inflation. In September 2008, the Fed embarked on a massive lending program. Its loans to financial institutions would increase from around $550.1 billion in early September to $1,571.2 billion by mid-November. Its loans to key credit markets would increase from $29.2 billion to $362.4 billion over the same period. But the Fed no longer held sufficient Treasuries to offset its expenditures. It would not be able to maintain the size of its balance sheet and engage in the lending and other asset purchases it thought necessary. Fearing inflation, and committed to increasing its balance sheet, the Fed While the Fed has lacked a high degree of de jure independence since its founding, it appears to have enjoyed a high degree of de facto independenceat least during the period widely known as the Great Moderation. 25 Its new operating regime, adopted in October 2008, has reduced the Fed's de facto independence though, despite leaving its de jure independence unchanged. 26 (2020) suggest that the Fed might have entered a "third regime" in June 2018, where "banks simultaneously choose to hold positive levels of excess reserves and engage in interbank lending." It is too early to tell whether the Fed will remain in the third regime, if it has in fact transitioned, or revert to a more conventional floor system. However, the third regime is sufficiently similar to a conventional floor system so as not to invalidate the more general argument regarding de facto central bank independence presented herein. IOR is set by the seven members of the BOG. Hence, the move from corridor to floor system reduced the set of relevant decision makers and, correspondingly, increased the power of each appointment. In fact, the reduction in de facto independence through the appointments channel is even greater than implied above. Recall that the FOMC consists of seven members of the BOG and five regional Reserve Bank Presidents. Unlike members of the BOG, who are appointed by the President and confirmed by the Senate, regional Reserve Bank Presidents are appointed by their regional Reserve Bank's Board of Directors and confirmed by the BOG. Hence, the new operating regime reduced the set of relevant decision makers by disenfranchising those furthest removed from political influence. One might be reluctant to believe the BOG would ever take advantage of its IOR-setting power to influence monetary policy. Doing so would require choosing an IOR inconsistent with the FFR, which would place BOG mem-12 J o u r n a l P r e -p r o o f bers in the awkward position of having to explain why the Fed is failing to hit its FFR. Indeed, the BOG maintains that it sets the IOR in consultation with the full FOMC. And, at least to date, the BOG has set the IOR in a manner consistent with FOMC decisions. There is, however, a precedent for using administered rates to override instruct the open market desk to execute "a 'pass-through' change in the funds rate for 'technical reasons.'" It is, therefore, not unreasonable to think the BOG might similarly use its IOR-setting power if ever its members find themselves in the minority of the FOMC. That the BOG has conducted monetary policy in line with FOMC decisions to date does not negate our position. For starters, it does not imply the BOG will continue to do so. Furthermore, since the FOMC now sets a FFR range, the BOG has some scope to influence monetary policy without formally overriding FOMC decisions. Chair Powell has described changes to IOR within the FFR range as "small technical adjustments," but they arguably permit the BOG to tweak the stance of monetary policy on the margin. One need not believe that the Fed's new operating regime strips regional Reserve Bank Presidents of all power to conduct monetary policy. To the extent that it shifts any power from regional Reserve Bank Presidents to members of the BOG, the new operating regime increases the appointment power of the President. The Fed's policy of paying IOR affects its remittances to the Treasury in two ways. The direct effect of the policy is to reduce the amount it remits. When the Fed pays more to large banks and foreign financial institutions, it has less to remit to the Treasury. But there is also an indirect effect. By paying IOR, the Fed is able to maintain a much larger (and, arguably, riskier) balance sheet, which results in correspondingly larger revenues. This indirect effect enables the Fed to increase its remittances to the Treasury. To date, the indirect effect has dominated. Annual remittances from the Fed to the Treasury have been significantly greater in recent years. But the direct effect is much more salient than the indirect effect. As a result, the Fed's policy of paying IOR might easily be construed as making transfers from the American taxpayer to large banks and foreign financial institutions. 27 Our estimate of total reserves includes vault cash, cash items in process of collection, balances due from depository institutions, and balances due from Federal Reserve Banks. Craig et al. (2015) maintains that cash holdings are a reasonable proxy for total reserves. 28 Keating and Macchiavelli (2017) find that U.S. branches and agencies of foreign banks capture much of the arbitrage business made possible by the floor system. Large domestic institutions also gain, while the pass-through from unsecured borrowing to reserve balances for small domestic banks is not significantly different from zero. Perhaps most significantly, the Fed's new operating regime eliminates its primary objection to conducting fiscal policy on behalf of Congress. "Once the demand for reserves is satiated," Plosser (2020) writes, "there is no limit, in principle, to how big the balance sheet or volume of reserves can be. A large balance sheet unconstrained by monetary policy is ripe for abuse. Congress and an administration would be tempted to look to the balance sheet for their own purposes, including credit policy and off-budget fiscal policy." 30 And, when they do so, the Fed will be unable to push back on the grounds that conducting fiscal policy would undermine its ability to maintain price stability. Plosser (2020) instructed the Fed to engage in "up to $2.3 trillion in lending to support households, employers, financial markets, and state and local governments" (Cheng et al. 2020 ). In adopting its new operating regime, the Fed has exposed itself to a greater degree of political influence. By reducing the set of decision makers to the BOG, the transition to a floor system increased the appointment power of the President. By giving Congress political ammunition to use against the Fed and eliminating the Fed's primary objection to conducting fiscal policy on behalf of Congress, the new regime has increased the bargaining power of technical improvement. Beckworth (2018), for example, maintains that paying IOR tends to produce tight monetary policy. See also : Hogan (2018) . 30 Selgin (2020) refers to such efforts as "fiscal QE" and traces the history of the idea. Congress. Hence, through both channels previously identified in the literature, the Fed's regime change reduced de facto central bank independence. Although the Fed is often billed as an independent agency, it is nonetheless subject to political pressure. The appointments process and congressional oversight provide two channels through which monetary policy might be influenced by short-term politics. And its new operating regime, whereby monetary policy is conducted by adjusting IOR, is marked by less de facto independence than the preceding regime through both channels. An obvious solution to restoring the Fed's independence would be to return to a corridor system, where decisions are made by the FOMC, the Fed does not make sizable interest payments to large banks and foreign financial institutions, and traditional arguments against using the monetary authority to conduct fiscal policy hold. Short of that, there are several partial measures the Fed might take. For one, it could modify its rules such that all FOMC members are involved in the IOR rate-setting decision. The Fed might also improve its communications to the public with respect to the broader benefits of paying interest on reserves and the desirability of limiting it to the conduct of monetary policy. Although none of these measures will make the Fed truly independent, they would go a long way toward restoring the level of de facto central bank independence enjoyed in the past. 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