Fed Independence is Sacrosanct
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When it comes to Congressional oversight of the Federal Reserve and its Open Market Committee, the line many policymakers wish to draw is between monetary policy decisions and actions to support financial stability. Calls for oversight, it is argued, cannot be used as pretext for compromising the independence of monetary policymaking, which serves as the foundation for price stability. This is the thinking embedded in the “compromise” Sanders amendment to the pending financial regulatory reform bill.
This is a reasonable enough framework for thinking about the proper scope of Congressional audits, which is probably why it has gained so many adherents. The problem is that when one gets into specifics it is not clear what is and is not monetary policy. Moreover, when reviewing the wealth of information available on the websites of the Board of Governors and Federal Reserve Bank of New York (FRBNY), it is not obvious what could be gained from additional disclosures. Given the difficulty of defining “monetary policy” and the very questionable informational benefits likely to be provided by an audit, Congress should resist the temptation to politicize Fed decision making – a long-standing objective of the extremes of both parties. If Congress is scandalized by the steps the Fed took to rescue a financial system in crisis, it should pursue financial regulatory reforms to reduce the probability that a crisis would again engulf the system.
Each Thursday at 4 pm, the Board of Governors publishes an update on its balance sheet, which provides a detailed accounting for each category of assets held by the Federal Reserve System. If one wishes to get more details on the Fed’s holdings of mortgage-backed securities, for example, he or she need only go to the detailed purchase and sale archives on the FRBNY website, which provide details on the face value, government-backed issuer, coupon, and settlement month for each security. The same data are available for Treasury note purchases.
The FRBNY provides detailed information on the types of acceptable loan collateral, the applicable interest rate, the maturity, and specific transaction details for the Term Asset Backed Securities Loan Facility (TALF). The same level of transparency existed for the programmatic details of the now closed Money Market Investor Funding Facility, Commercial Paper Funding Facility, Term Securities Lending Facility, and Primary Dealer Credit Facility.
If anyone wishes to know the types of collateral accepted or the interest rates charged on secured loans, the Fed has a discount window website that provides all of the relevant details. The Board of Governors also provides full details on the support it provided – in conjunction with the Treasury – to specific institutions. The FRBNY’s website contains the details on every security acquired as part of the Bear Stearns and AIG bailouts, including the remaining principal balance and individual CUSIP number. These holdings are also subject to annual audits.
While this information is more than adequate for those interested in understanding the mechanics of the emergency lending programs that saved the global financial system, it does not suffice for conspiracy theorists eager to tie the Fed to Saddam Hussein and Watergate. Since every $100 bill circulating internationally is a Federal Reserve Note, it is not unreasonable to think extremists could tie the Fed to funding for international terrorism, the narcotics trade, or whatever other illicit transactions are conducted with U.S. dollars.
More likely, the opponents of Fed independence want an audit for details of large loans extended to huge banks in the dark days of 2008 and early 2009. Then, these Fed critics could feign shock(!) at the discovery that the central bank extended secured loans to institutions that needed to fund illiquid positions in the grip of a panic (i.e. the function of a central bank).
Indeed, one institution in particular is likely to be the focus of the inquiry. After the Fed granted Goldman Sachs and Morgan Stanley Bank Holding Company status in September 2008, these institutions became eligible to borrow from the Fed “against all types of collateral that may be pledged at the Federal Reserve's primary credit facility for depository institutions.” Both Morgan Stanley and Goldman Sachs were facing huge client withdrawals on top of the difficulty rolling over financing in the money markets and likely needed billions in Fed loans to stay afloat. While one might point to this episode whenever a Goldman executive suggests their firm could have survived absent government support, the Fed not only did the right thing, but by lending freely against good collateral it performed its most basic and elemental monetary policy function.
Since the publication of Walter Bagehot’s Lombard Street in 1873, informed observers of the money markets have generally agreed that the key monetary policy function of the central bank in a panic is to lend freely so as to end the panic. When Bagehot wrote, a key concern was the solvency of the Bank of England, given its finite supply of gold that backed the currency. To prevent the exhaustion of reserves, Bagehot cautioned that the Bank of England could lend only at a penalty rate and against banks’ high-quality collateral. But when panics ensue – i.e. when the only asset participants wish to hold is currency (or a metallic store of value like gold) – the central bank has no choice but to provide currency to all comers able to pledge reasonable collateral. To arrest the panic of 1825, the Bank of England lent directly to merchants, often against nothing but their personal credit. Indeed, Milton Friedman cited precisely this example of the Bank of England’s free lending when explaining what steps the Fed should have taken to combat the onset of the Great Depression.
At its most basic, monetary policy is about shaping the terms and speed at which currency is transformed into financial claims. Investment in a modern economy is financed by velocity-increasing, liquidity-decreasing portfolio transformations facilitated by the financial system. Currency is turned into deposits (a claim on a bank), which are turned into loans, which are then turned into new productive equipment at a business. The resulting liability structure – industrial firm owing the bank, which owes the depositor – can come unwound suddenly, causing an immediate reversal of the liquidity transformation when the panicked depositor wants his currency back from the bank. When the currency is not available because it is in the form of new productive equipment, the central bank is not supposed to simply sit back and watch the bank fail. The role of monetary policy in this case is to “monetize” the bank’s loan to the industrial firm through a temporary liquidity injection so the bank can return the currency to the depositor until the panic subsides.
As economists Tobias Adrian and Hyun Song Shin explain in a seminal 2009 article published in the American Economic Review, “Contrary to the common view that monetary policy and policies toward financial stability should be seen separately, they are inseparable.” To define “monetary policy” as setting a fed fund rate target with the aim of affecting a specific percentage change in the consumer price index (CPI) would be to miss the balance sheet adjustment processes at the heart of monetary policy.
As we found out during the financial crisis, there is a fine line between fiscal and monetary policy. If monetary policy involves lending against “good collateral,” then the central bank’s ability to assess collateral quality is paramount since the power to accept credit risk – i.e. to lose money on a loan – is inherently fiscal since it involves the power to spend. While the loan to acquire the Bear Stearns assets comes very close to crossing this line, subsequent actions involving even a hint of credit risk were all taken with the loss layer of capital provided by Treasury (through Congress).
Congress is well within its rights to argue that the haircuts set on various types of collateral are too small, or that secured term loans are not properly “monetary.” But that’s not what this audit of the Fed is about. Congress should not give into the temptation to politicize the Fed through a compromise that narrowly and erroneously defines monetary policy and compromises the central bank’s independence.