The Fed Can’t Choose When to Be Independent

Policy independence is a core tenet of central banking: The Federal Reserve System (Fed) must be able to set policy without short-run political interference to achieve its statutory mandates. A complement to this tenet is that the Fed must operate strictly within those mandates and comply with its long-standing Accord with the Department of the Treasury, in which the Fed governs monetary policy but leaves fiscal policy to Treasury and the White House.

Congress has delegated to the Fed substantial authority to create money and thereby influence interest rates, inflation and economic performance. This delegation and related independence, however, should not mean carte blanche in how the Fed interprets this authority. Without firm boundaries around discretion, Fed policy becomes susceptible to political, financial, labor and corporate influence, which ultimately diminishes its credibility. History provides ample evidence of such outcomes.

Congress did assign the Fed boundaries, or mandates, to pursue stable prices, maximum employment and moderate long-term interest rates (12 U.S.C. §225a). Over time, however, under the banner of independence, the Fed has broadened its interpretation of these mandates and how best to achieve them. During the Great Financial Crisis (GFC) the Fed began supporting housing credit with its purchases of agency mortgage-backed securities (MBS). It conducted large-scale asset purchases (that is, quantitative easing) and managed the yield curve to provide abundant market liquidity, increase asset values and stimulate aggregate demand. These actions were taken during exigent circumstances and accepted as necessary for financial and economic stability.

As often happens following a crisis, however, these actions and their rationale were woven into the Fed’s ongoing policy framework. In 2010, following the GFC and without congressional approval, the Fed adopted quantitative easing as a principal policy tool and kept the fed funds rate near zero even as the economy recovered. Over a four-year period, the Fed more than doubled its balance sheet as it purchased government and government-guaranteed debt, with too little evidence that the purchases would enhance long-term productivity or real wage growth.

Then, in 2012, the Fed unilaterally defined price stability, not as zero, but as 2% inflation. During and (more significantly) following the pandemic, the Fed funded a majority of newly issued federal debt to facilitate the government’s fiscal expansion. With substantial funding support from the Fed, the national debt increased from about $8 trillion in 2005 to nearly $33 trillion in 2022 while long-term interest rates were kept muted. Today the national debt is approaching $38 trillion. It appears that the Fed has voluntarily subordinated its policy to congressional deficits.

For most of the past two decades, the Fed has repeatedly intervened to assure a smoothly functioning Treasury market and short-term financial calm. In doing so, it has created the expectation that it will do whatever it takes to support these markets and related interest rates, which has made it increasingly difficult for the Fed to say no to political and financial interests. This expectation will only deepen as the national debt accelerates and Treasury looks to the Fed to monetize the debt and suppress interest rates, further subordinating itself to Treasury. Fed independence is under threat, and this threat is difficult to defend for a Fed whose policy is increasingly entangled with fiscal policies.

There is, however, a better path forward. Following World War II, the federal debt also had increased above GDP and was costly to service. Treasury was insisting that the Fed continue to peg interest rates and monetize the debt. At the same time, inflation was rising, and the Fed found itself unable to both serve the Treasury and control inflation, which ultimately led to a clash between institutions.

Finally, in 1951, after tense discussions between the White House/Treasury and the Fed, an agreement was reached that acknowledged their separate duties within the government and the economy. This Accord acknowledged the Fed’s autonomy and recognized that it was not obligated to monetize federal deficits or peg the yield curve, as Treasury had come to expect. The Fed was solely responsible for monetary policy, focused on price stability and long-term employment. In contrast, Congress and the Treasury were responsible for fiscal policy and managing the debt load. This was a pivotal agreement ending years of Treasury-dominated monetary policy.

As important as this agreement was for Fed independence, the more critical outcome was that it confirmed that Congress was responsible for the nation’s debt. Congress and Treasury could not expect printing money to substitute for spending constraints or tax increases in managing the nation’s fiscal program. And what was the result? During the decade following the Accord, the gross federal debt-to-GDP ratio declined from approximately 90% in 1949 to 55% in 1959, and the annual federal deficit-to-GDP stayed below 2%. Real GDP growth averaged just over 4%, CPI inflation averaged 2%, and the unemployment rate averaged 4.6%. Although Fed controlled interest rates increased from their pegged levels, they averaged about 2.5% over the period and at no time exceeded 3.5%. We can only speculate on what the outcome would have been without the Accord, and Congress and Treasury accepting their responsibility to manage the nation’s budget.

Economic conditions are different today, but the lessons of this earlier period still apply. Over the past two decades the Fed has again taken on a greater role in fiscal policy. Under headings such as “the only game in town” and a “smoothly functioning Treasury market,” the Fed turned emergency liquidity facilities into ongoing Treasury accommodation, and if federal deficits continue at their current pace, the Fed will be pressured to continue doing so. Under these conditions, a realistic assessment of the future must include a sharp rise in consumer prices and an explosion in asset prices.

It is time to revitalize the Accord. The Fed should focus on its primary mandate of stable prices and maximum employment. It should stop interpreting the mandate to cover every contingency. Congress and the Treasury should again be responsible and accountable for fiscal policy and address the out-of-control growth in debt. If Congress fails to do so, under the Accord, higher interest rates must follow as the Fed can no longer monetize the debt and suppress interest rates. In contrast, if the debt is managed more responsibly, prices and interest rates will stabilize, business and consumer confidence will rise, and more sustainable economic growth will result. Yes, if the economy experiences acute stress—such as a liquidity crisis or systemic risk—the Fed is empowered to provide temporary liquidity relief, but there should be a hard limit in its duration.

Finally, policy independence, while a core principle of central banking, is of little value if central bankers fail to confine themselves to their mission. There are many challenges that a central bank confronts, but the most challenging is the belief that the Fed can solve all economic problems with the push of its money creating button.