Texas Tech University

Thoughts on "Auditing the Fed" - Dr. Scott E. Hein, Robert C. Brown Chair in Finance

Trevor Bell

March 12, 2015

Dr. Scott E. Hein, Robert C. Brown Chair in Finance at the Rawls College of Business, shared his views on the Federal Reserve. For any questions or to receive more information, contact Dr. Hein at scott.hein@ttu.edu.

Thoughts on “Auditing the Fed”

The irony of events unfolding surrounding the political independence of the Federal Reserve System these days is too rich for words. First, came word of a bill in Congress aimed at "auditing the Fed's monetary policy actions." Then, Federal Reserve officials came out and warned, rightfully, against making the Fed too dependent on political forces. And now, word comes out that the same Fed officials are "cultivating stronger GOP ties."

If you are confused by this unfolding of events, you have every right to be. It is obvious to me that the Fed is itself conflicted and really doesn't know what it wants. The truth of the matter is that our Federal Reserve System was established by Congress over one hundred years ago and in this establishment, it was given some explicit independence from Presidential and Congressional election cycles. Indeed, this is a nice attribute, but one that has limits. It is important to understand that Congress, as our law setter, has every right to reconsider the Fed's set up and ask if things could have worked out better with different arrangements. In this vein, however, the use of the term "audit" is a serious exaggeration, as it suggests the case can be decided on the basis of facts alone, which doesn't seem to fully apply in this case.

While most commentators today want to weigh in on whether or not Congress should "audit the Fed", I think they are missing a subtle, but more interesting question. The question I am thinking of is the more positive question: 'Why is this change being proposed and discussed now?' In other words what is driving the timing of today's conversation in Congress?

My answer to this question is that it is really a reflection of the political forces in Congress, and to a certain extent society. These forces suggest to me that the Fed has been taking monetary policy actions that many are not fully satisfied with. Indeed, over the course of the Fed's history there have been periodic, serious missteps regarding the Fed's ability to maintain full employment and price stability, the mandates set for the Fed by Congress. The Fed has been correctly criticized extensively for poor policy choices during the Great Depression, for example, making the economic troubles worse rather than better. And the Fed took actions in the late 1960s and 1970s that only made the inflation problem worse at that time. In each of these cases there were political discussions that changes should be made to improve monetary policy actions. And such discussions were and are warranted, as we learned much from them.

What has the Fed done wrong recently with monetary policy to warrant questioning whether things could have gone better? Having only recently put much of the lingering effects of the financial crisis behind us, I think the answer is obvious. John Taylor (the Stanford economist, not the football player or the rapper) and others have argued that excessively easy money policies in the early to mid-2000s were at least partially to blame for the excesses that lead to the financial crisis (see the Federal Open Market Committee target for the federal funds rate below). As the Fed reacted to current economic data, rather than being forward looking, they started to normalize interest rates only gradually - taking almost two years, something eerily going on today. Then they were somewhat slow in recognizing the financial crisis and subsequent recession. And most critically, they adopted critical "emergency" policies by the end of 2008 apparently picking certain winners and losers among financial players. Finally, today these emergency policies of targeting short-term interest rates to be close to zero still remain in place, even when our economy has created over 1 million new jobs in three months, and inflation has exceeded one percent (admittedly low by historical standards, but well above the nominal return to investors that seek safety in their investments).

scottheingraph
Source: Federal Reserve Bank of St Louis, Monetary Trends, February 2015.

In addition to targeting short-term interest rates to be near zero in response to the recession and financial crisis, the Fed has engaged in three different phases of quantitative easing, only recently ending the latest episode. The aim of this policy has been to lower longer-term interest rates. Ironically, long-term interest rates have fallen since the Fed stopped buying these securities last October, raising legitimate questions about the efficacy of this program. And even if this program was successful in lowering long-term interest rates, as aimed, one has to ask if it makes sense to penalize "widows and orphans" that live on such earnings, just to encourage others to borrow more. On top of this, the Federal Open Market Committee has set an explicit target for their inflation measure to be 2% a year. With this target, prices will nearly double over a retired person's lifetime. How is this "price stability"?

In other words, there is much to question in the Federal Reserve's monetary policy actions of late and it is appropriate to ask if we could improve things by making changes in our Federal Reserve System. If it is right for NBC to suspend Brian Williams for embellishments of his experiences, isn't it also right for Congress to review the record of the Fed regarding their recent actions, and ask if we can improve upon what has been done?

One very minor change that in my view would potentially improve monetary policy decisions would be to change those that get to vote at Federal Open Market Committee meetings. Currently, when fully staffed, all seven Board of Governors get to vote, but only five of the twelve district bank Presidents get to vote (with the New York Fed President always allowed to vote, and the others rotating on an annual basis). I have long felt that this process vests too much monetary policy decision making authority centrally in Washington DC, and not enough from the rest of the country. It also fosters too much "group think". For example, I believe the records of votes in recent years documents relatively more dissents on behalf of the district bank Presidents in FOMC deliberation than from Board of Governors. Board members are all feed the same input from the Board staff, and as much as this staff is qualified, they don't have exclusive understanding of economic forces. Encouraging a little more critical, independent thought in my view would be beneficial for our monetary policy deliberations.