Economics

Fighting the Fed

Jul 23, 2014 Martin Feldstein

The US Federal Reserve fears that a proposed law requiring it to use a formal rule to guide monetary policy would limit its independence, while the bill’s proponents argue that it would produce more predictable growth with low inflation. Who is right?

CAMBRIDGE – The US Federal Reserve is battling with members of Congress over a proposed law, the Federal Reserve Accountability and Transparency Act, that would require the Fed to use a formal rule to guide monetary policy. The Fed fears that the law would limit its independence, while the bill’s proponents argue that it would produce more predictable growth with low inflation. Who is right?

In order to understand the conflict, it is useful to compare the Fed’s independence with that of the Bank of England and the European Central Bank.

In Britain, the BoE has “instrument independence” but not “target independence.” The head of the Treasury sets a goal for the inflation rate and leaves it to the BoE to decide which policies will achieve that goal. If the target is missed by more than one percentage point on either side, the BoE’s governor must send an open letter to the head of the Treasury explaining why (and what the Bank proposes to do about it).

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Martin Feldstein

Writing for PS since 2008
130 Commentaries

Martin Feldstein was Professor of Economics at Harvard University and President Emeritus of the National Bureau of Economic Research. He chaired President Ronald Reagan’s Council of Economic Advisers from 1982 to 1984. In 2006, he was appointed to President Bush's Foreign Intelligence Advisory Board, and, in 2009, was appointed to President Obama's Economic Recovery Advisory Board. He was also on the board of directors of the Council on Foreign Relations, the Trilateral Commission, and the Group of 30, a non-profit, international body that seeks greater understanding of global economic issues.

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pieter jongejan Jul 26, 2014

Martin Feldstein misses the point that other central banks are fully dependend of the FED's monetary policy. Lower interest rates in the USA imply higher exchange rates in Europe and other Western countries. In order tp prevent deflation these central banks are forced to lower their interest rates as well. Therefore it is important to understand why the FEd wants interest rates to stay low for ever. The Fed's monetary policy is based on teh assumption that lower (real) interest rates will stimulate investment, exports, economic growth and employment. Republicans fear higher inflation. Both parties seem not to bother about the facts, which point in a total different direction. After the liberalization of financial marktes in 1982 (in response to the rise of short term interest rates by Volcker) the negative relation between (real) interest rates and inflation has been transformed into a positive relation. Therfore we need higher and not lower (real) interest rates if we want to stimulate economic growth, investment growth and employment. A higher real interest rate will result in a stronger American dollar (like the Swiss franc) and thus in lower import prices and lower inflation. The conclusion is that republicans, democrats and the FED should opt for higher real interest rates.
Why are higher real interest rates resulting in higher investment ratios? The answer is thta higher real interest rates will result in lower asset values and thus in a higher profit rate. Lower real interest rates will on the contrary esult in lower profit rates, lower investment, lower economic growth an dhigher unemployment. Why does the FED not understand how the economy works?
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kiers sohn Jul 25, 2014

In the end it's a silly point to make because ALL the data are political and ALL the data are "fake". They are already cooking up inflation numbers to meet targets so who cares if they cook up policy to meet inflation numbers.

It won't impact FED independence ONE iota, except the media will sanctimoniously chatter
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Michael Heller Jul 25, 2014

Martin Feldstein provides wonderfully clear summary of the issues, with additional useful comparisons between UK, EU, USA monetary policy frameworks. Rules vs discretion in economic policy is possibly the most important debate on the planet now, so the public needs to know (from people who know).
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Stamatis Kavvadias Jul 24, 2014

This is supposed to be a serious discussion? Inflation is at 1,5% and republicans are trying to restrict FED's freedom of setting the threshold for the inflation target that, roughly, allows for respecting the employment target, "because they need to make sure inflation will not exceed 2%" ?????

This is just making employment a "secondary-target" (in fact a non achievable target), canceling the current mandate, just not calling it that.

The basic problem that democrats have to address is that the current mandate does not specify who (e.g., which body or institution) *and how* should define "maximum employment" for the current state of the economy, and if it the target value of interest is a medium term average or a threshold. To make this reflect targets set by government (leaving instruments to the FED), the institution defining "maximum employment" should be part of the government. In my opinion, the "how" of defining "maximum employment," should be set by legislation and not under Treasury control.

At the same time, the FED should be allowed short-term biased targeting of inflation against employment and the other way round, in difficult times (i.e., if only the economy is -already- in a weak state; such states need to be defined and the FED should report on them).
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