Discussion about more political oversight or political control of the U.S. Federal Reserve (Fed) occasionally heats up. We are seeing more of this type of discourse today as the election approaches. In our view, limited Fed independence could prove disastrous. While we can be critical of Fed policies, history shows that more political influence can make the situation worse, not better.
What is the U.S. Federal Reserve?
The U.S. Federal Reserve, often called “the Fed,” is the central bank of the United States. It was created in 1913 to provide a safer, more flexible, and more stable financial system. The Fed has several important jobs:
- Conducting monetary policy.
- Supervising and regulating banks.
- Maintaining the stability of the financial system.
- Providing certain financial services to the government and public.
How does the Fed work?
The Fed’s main tool for influencing the economy is monetary policy. This involves managing the money supply and interest rates to promote maximum employment, stable prices, and moderate long-term interest rates.
The Federal Open Market Committee (FOMC) is responsible for setting monetary policy. It consists of:
- The seven members of the Board of Governors.
- The president of the Federal Reserve Bank of New York.
- Four of the remaining eleven Reserve Bank presidents, who serve one-year terms on a rotating basis.
What are some risks of political appointees in monetary policy?
While the President appoints the members of the Board of Governors with Senate confirmation, the Fed is designed to be independent from short-term political pressures. However, there are risks associated with increasing political influence on monetary policy:
- Short-term thinking: Politicians often focus on short-term gains that may help them get re-elected, rather than long-term economic stability.
- Inflation risk: Political pressure could lead to policies that boost economic growth in the short term but cause high inflation later.
- Loss of credibility: If the Fed is seen as a political tool, it may lose credibility in financial markets, which can make its policies less effective.
- Policy instability: Monetary policy could change dramatically with each new administration, creating economic uncertainty.
Are there historical examples of political influence that have gone wrong?
Yes, there are many examples when political influence on the Fed has damaged economies:
- Nixon and Arthur Burns (1970s):
- President Nixon pressured Fed Chairman Arthur Burns to keep interest rates low before the 1972 election.
- This contributed to high inflation in the mid-1970s, which took years to bring under control.
- Turkey’s recent experience:
- President Erdogan has pushed for low interest rates despite high inflation.
- This has led to runaway inflation and a crash in the value of Turkey’s currency, the lira.
What are the dangers of giving politicians more control?
Some people argue for giving elected officials more control over monetary policy. However, this could be risky:
- Policy flip-flops: Different parties might dramatically change monetary policy when they come to power, creating economic instability.
- Lack of expertise: Politicians may not have the specialized knowledge needed to make complex economic decisions.
- Conflicting goals: The goals of good monetary policy (like price stability) might conflict with short-term political goals.
Conclusion
While the U.S. Federal Reserve system isn’t perfect, its independence from direct political control is an important feature. This allows for a more consistent and longer-term focused monetary policy that aims to benefit the entire economy, not just short-term political interests.
Constructive criticism of Fed policies is healthy and necessary. However, maintaining the Fed’s independence from direct political control helps ensure that monetary policy decisions are made based on economic data and analysis rather than political expediency.
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