How The Federal Reserve Can Maintain Its Independence

those people missed mortgage payments, and applying for unemployment benefits takes time, she noted. “Small [financial troubles] can have very big effects on individuals, on families and on small businesses,” she said. “Often, families, individuals and small businesses are interconnected, so there is something that we could do [for them], especially with government contractors.”

Areas of Agreement

Janet Yellen had to “toe a difficult line,” said Zaring, referring to her willingness to review financial regulations, even as she disagreed with attacks on the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. “She feels that Dodd-Frank is working and that it shouldn’t be repealed or re-jiggered in the way that the President and his treasury secretary suggested is appropriate.”

Meanwhile, the Fed is not taking a hard line on regulation, Zaring noted. He referred, for example, to Yellen suggesting in her testimony that Congress might want to consider exempting some smaller community banks from the Volcker Rule (which sought to prohibit banks from making speculative investments that do not benefit their customers). “[Then], maybe those smaller banks are more receptive and likely to help out small businesses with the financing they need,” he said.

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According to Schwarz, a full-blown repeal of Dodd-Frank is unlikely, but parts of it may well be amended by Congress. In any event, she said the executive branch of the new administration “is clearly going to take a much softer line on financial regulation.”

Retaining the Federal Reserve’s Independence

Schwarz said the continued independence of the Fed is a looming concern. “We are in the early days of the new administration, and the noise-to-signal ratio of news in this regard is high at present,” she said. “But, some of the bills that have been proposed in Congress and some of the statements made by Trump on the campaign trail could indeed raise worries about Fed independence if these were to become a more clear course of policy.”

Schwarz explained why the Fed’s independence is critical. “A central bank’s independence is the cornerstone of its ability to execute effective monetary policy,” she said. “A lack of independence confers a lack of credibility in the institution’s policy motives. An infringement on the Fed’s independence would be a very bad outcome. Credibility is crucial to anchoring inflation expectations and guiding investment and savings decisions in the economy.”

Cook said that while the White House and the Federal Reserve communicate with each other during “times of crisis,” or even during normal times, there is no congressionally mandated requirement for the Fed chair to make presentations to the President. However, the Fed chair is required to make periodic presentations to Congress, she added.

That said, how Fed chairs have related to the President has varied in history, said Cook. Alan Greenspan, for example, “made sure that he stayed in the good graces of [Bill Clinton],” she noted. But Paul Volcker, who served as Fed chair under Presidents Jimmy Carter and Ronald Reagan, took a different approach, she said. “He just hiked interest rates out of this world, he contained the inflation rate and it actually worked.” Ben Bernanke had “a good working relationship in managing the financial crisis,” but he crafted his approaches in consultation with representatives of the Bush and Obama administrations, she added.

A big factor in how Fed chairs relate to the President is a concern about how history will record their work, according to Zaring. “One of the things that Fed chairs think about when they think about their legacy is how independent were they from the President, and there are a lot of things that go into that independence calculation,” he said. For instance, Arthur Burns, the Fed chair from 1970 to 1978, “was thought to be too close [to Richard Nixon], and it’s hurt him as far as the way he is viewed by people today,” he recalled. “So Fed chairs have a legacy-oriented reason to keep their distance, and that arm’s length relationship characterizes — maybe with the exception of Greenspan — most of the recent chairs.”

“It would be a shame and very difficult if there were a loss of memory of how the financial crisis came about and why this regulation … was put in place.”–Lisa Cook

Both Cook and Zaring were concerned about the possibility that Yellen could step down before her term expires. President Trump has said he would like to replace Yellen when he gets a chance, but Yellen has made it clear that she will complete her term. But “this environment is poisonous,” said Cook, referring to the rumor mills suggesting that she may quit. “I lived in Russia, so I saw how that can happen, but it happens in this country, too.” She added that it would make it easier for Trump to replace Yellen if there were a rumor that she was ready to step down. In any event, Yellen could stay on as a member of the FOMC until January 2024, Zaring noted.

Cook noted that Yellen has risen through the ranks of the Federal Reserve and is “very popular” internally in her organization. Yellen has also ensured open communication channels, she said. “She is a person who allows information to flow to the top.”

Stirrings of a New Order

While the Fed and the regulatory regime face headwinds, regional Federal Reserve banks could act as an effective check, said Zaring. “One of the reasons they are so important to the way the organization works is because we were always uncomfortable in America with an almighty central bank so they tried to create these regional institutions that could check the power of one all-powerful Fed chair,” he said. Regional banks also serve an important function in interacting with the businesses in their communities, he added. “In addition to being this trust of the central government, it is also a means by which there can be a flow of information,” said Cook.

Zaring noted that even if Congress and the President want to roll back regulations, they cannot have it their way all the way. “The Fed is still going to be there in bank holding companies, supervising their day-to-day activities,” he said. “That informal oversight can really retain a lot of regulatory supervision.”

Replacing the old guard in monetary policy and bank regulation with new faces could have damaging effects, according to Cook. “It would be a shame and very difficult if there were a loss of memory of how the financial crisis came about and why this regulation … was put in place,” she said. While some aspects of laws and regulations could be tweaked, “there has to be some institutional memory,” she added. “There has to be a memory about what was happening before our system was going gangbusters and the economy was growing and we were adding jobs like we are now. There has to be sensitivity to that, and to protecting consumers.”

Article by Knowledge@Wharton