The Elusive Quest for Effective Monetary Oversight
Many countries insulate their central banks from political pressures. This does not mean, however, that a central bank should be unaccountable for its actions. In striking a balance between independence and accountability, legislative bodies typically have exercised oversight of a central bank by establishing monetary policy goals and reviewing whether those goals have been achieved. For more than two decades now, U.S. legislators have struggled to find the correct approach to Fed oversight and reform. A comparison of two specific attempts to do so, one from 1995 and another much more recent, illustrates what a tricky task this can be.
Our previous column for E21 discusses the Federal Reserve Oversight Reform and Modernization (FORM) Act, which was passed by the House of Representatives last November and now awaits passage by the Senate. This Act requires the Fed to adopt a “Directive Policy Rule” to guide its settings of the federal funds rate target. Legislators would judge the Fed based on how closely the actual funds rate tracks the settings prescribed by the Directive Rule as well as a “Reference Rule” determined by Congress. Although the Act offers no specific guidance on the ultimate goals on monetary policy, the Reference Rule acknowledges the Fed’s current “dual mandate” by incorporating terms that would minimize the output gap as well as deviations of inflation from a target of two percent. Most readers will recognize this formulation as a standard Taylor rule.
It is instructive to compare the current discussion of monetary policy rules against a 1995 proposal to adopt the Economic Growth and Price Stability Act. This earlier legislation, which would have repealed the “Humphrey-Hawkins Act” of 1978, required the Federal Reserve “to focus on price stability in establishing monetary policy.” The rationale for this mandate was that “the conditions and goals established by the Full Employment and Balanced Growth Act of 1978, have not been and could not be met, and continue to cause confusion and ambiguity about the appropriate role of monetary policy.” The draft bill argued that “the multiple policy goals” prescribed by Humphrey-Hawkins “have created uncertainty about the aims of monetary policy, which can add to volatility in economic activity” and claimed that “there is a need for the Congress to clarify the (Fed’s) proper role … in economic policymaking, in order to achieve the best environment for long-term growth and the lowest possible interest rates.” To this end the bill would have removed one component of the Fed’s existing dual mandate by specifying one primary long-term goal of monetary policy: “to promote price stability.” This legislation was put forward in 1995 and again in 1997 but never was enacted.
The best approach to Fed reform is an open question. It is important to note, however, that these two bills are very different. The 1995 bill claims that pursuit of multiple goals creates uncertainty about the future course of monetary policy and, by doing so, adds volatility to economic activity. Because the current FORM Act retains, at least in principle, the Fed’s traditional dual mandate, this legislative proposal apparently accepts any costs associated with that source of uncertainty in exchange for the presumed benefits of a rule that would limit the Fed’s discretion in setting a target for the federal funds rate.
While the 1995 proposal would have required to Fed to “establish an explicit numerical definition of the term ‘price stability’” and evaluated the Fed by comparing this numerical definition of price stability to the actual behavior of the aggregate price level, the FORM Act concentrates on the difference, if any, between the federal funds rate and the values generated by the Reference Rule. In general, the FORM Act concentrates on the mechanics of how the Fed determines its target for the funds rate and is less explicit about specific values for the ultimate objectives of monetary policy. The earlier Price Stability Act reverses these points of emphasis by requiring the Fed to be explicit about its definition of “price stability” but leaving the Fed with some latitude to determine how that goal is achieved.
Today, unfortunately, we seem to be experiencing negative consequences of both forms of discretion. The Fed operates without a well-articulated policy rule of the kind it would have to adopt under the FORM Act. This leaves the public guessing as to where interest rates are heading next. But the Fed also operates under a dual mandate that leaves unspecified the weights it should place on separate goals for unemployment and inflation. This leads to confusion as to what the Fed will do over longer horizons. Clearly, congressional oversight of the Fed needs improvement. But a comparison of past efforts to “reform the Fed” shows that accomplishing this goal is much more easily said than done.
Michael Belongia is a professor of economics at the University of Mississippi. Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market Committee.
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