GOP to Fed: Explain yourself

Since the Fed’s bailouts of banks during the 2008 financial crisis and its subsequent unprecedented stimulus efforts during the recession, conservatives spurred by populist anger have accused the central bank of acting without transparency or accountability and generating uncertainty.

Other populist efforts to rein in the Fed, such as Kentucky Sen. Rand Paul’s Fed audit legislation, have fallen short of becoming law. The move to force the Fed to tie its monetary policy decisions to a predictable rule, however, is becoming part of a long-term GOP reform platform.

The House in November passed legislation, called the FORM Act, that would reshape the Fed along many dimensions.

One of its provisions is a requirement that the Fed spell out a policy rule after each of its monetary policy meetings. The rule would require the central bank to state how it planned to move its target for short-term interest rates in response to changes in economic variables, such as inflation, economic output and unemployment.

The Fed would choose its own rule, subject to certain qualifications, and could change it whenever it judged necessary. And it would have to compare it to the “Taylor Rule,” a well-known monetary policy rule that relates the Fed’s target rate to inflation and economic growth.

In May, Senate Republicans advanced a similar reform, including a measure requiring the Fed to spell out a rule in a package of financial regulatory reforms authored by Senate Banking Committee Chairman Richard Shelby of Alabama that was passed by his committee.

Rep. Bill Huizenga, R-Mich., the author of the House bill and the chairman of the Financial Services subcommittee on monetary policy, told the Washington Examiner that he’s looking for ways to keep advancing the legislation. He hopes to include it in a broad financial regulatory overhaul bill that Financial Services Committee Chairman Jeb Hensarling is planning in response to House Speaker Paul Ryan’s call for the GOP to pass legislation defining its platform for the November elections. “I’m in for a long-haul conversation on this, it’s not a short-term thing,” Huizenga said.

Federal Reserve Chairwoman Janet Yellen wants the bill to fail. In a letter to Congress before its passage, she warned that it would “severely damage the U.S. economy,” a notably blunt warning coming from the Fed. The bill would “effectively cast aside the bipartisan approach toward monetary policy oversight developed by the Congress in the late 1970s,” Yellen warned, increasing political influence in monetary policy.

Currently, the Fed is required by Congress to pursue stable inflation and maximum employment, but is allowed to choose how it achieves those goals.

Yet the provision does have some support among academics, most notably from Taylor Rule namesake John Taylor, a prominent Stanford University economist and former George W. Bush Treasury official.

David Papell, an economics professor at the University of Houston, is one of the authors of research finding that the economy performs better when the Fed operates under rules. Furthermore, he adds, the legislation would require the Fed to publish only one more piece of information. “I think the Fed could do exactly what it’s been doing, but it would be required to do one more thing,” he said.

Requiring the Fed to spell out a rule for how it would conduct monetary policy, Papell said, “adds predictability. If you’re in an era — we’re talking about long periods of time, we’re not talking about month to month — where people have an idea of what the Fed is going to do … then they can plan, they can make investment decisions, they can have a better idea of what’s going on.”

Here’s how little would change: Fed members already review a range of policy options prepared by the Board of Governors staff at each meeting in a packet called the “Bluebook,” which includes a number of rules, including the Taylor Rule. Although opponents of Huizenga’s legislation have charged that it would subject the Fed to Government Accountability Office audits when it changed its monetary policy, the GAO in fact would become involved only if the Fed’s rule did not meet the minimum requirements spelled out in the legislation.

Yet Carl Walsh, a monetary economist at the University of California, Santa Cruz, argued that the legislation would represent a “fundamental shift” in monetary policy away from targeting stable inflation and full employment and toward targeting interest rate changes — a focus on instruments versus goals.

Even if the legislation doesn’t specifically require that shift, Walsh said, it would have the same effect. Because the Fed potentially would have to face an appearance before Congress each time it changed its rule, officials would “be more reluctant to deviate from the rule,” Walsh said.

Walsh’s own research found that forcing the Fed to follow a rule could work in some circumstances, depending on the central bank choosing the right model. But in other circumstances, it would hurt. One example is that of a financial crisis such as the one in 2008, when equilibrium interest rates fell steeply. The Fed responded by cutting rates all the way to zero and then attempting to further loosen money with bond purchases. In those cases, there is a “worry that if you tie the central bank’s hands too much you may lose that flexibility that you need,” Walsh said.

Huizenga said he was open to refining his legislation, but asserted that having the GAO and Congress review the Fed’s rule changes was a key component. “Kind of the point is you’ve got somebody else’s eyes on this thing,” he said.

It wouldn’t be the first time that Congress has moved to require the Fed to focus on moving an instrument. In 1977, Congress required the central bank to adopt targets for growth in the money supply. At the time, that was the prescription of the libertarian Nobel Prize-winning economist Milton Friedman.

Over time, however, it turned out that the Fed couldn’t be held to the rule, because there were enough different measures of money that the Fed could claim to meet its target even without solving the problem of out-of-control inflation.

The money supply targets were eventually dropped, and over time the Fed and other central banks shifted to the goal targeting regimes that are in place today. After the recession and the rise of populist anger at the Fed, however, a new push for rules for the Fed is underway.