President Trump’s return to the White House has sparked a resurgence of interest in central bank independence. Federal Reserve Governor Michael Barr said he would step down from his Vice Chair position earlier this month, avoiding a direct conflict with the administration that could have triggered his demotion or firing — and a lengthy court battle on the legality of such an action. President Trump has intimated he wants to replace Fed Chairman Jerome Powell and has explicitly stated his desire for lower interest rates, as well.
Many economists have cried foul. They worry President Trump will politicize monetary policy, removing the wall of separation between central banking and hardball politics. Subjecting Fed policymakers to the whims of politicians on short-term election cycles, they say, would result in higher inflation and greater financial instability.
Does that mean central bank independence is a good thing? Economists overwhelmingly think so. In developed countries, protecting the monetary authority from politics is so widely seen as desirable that it’s rarely discussed, let alone debated.
In fact, the empirical evidence on central bank independence is mixed. Some recent studies suggest a negative relationship between independence and inflation in developing countries. This appears to support the theoretical desirability of independence. But other studies with larger samples don’t find a relationship; there is significant heterogeneity in the effects. In layman’s terms: it’s complicated, and depends greatly on a country’s political and economic context.
For example, central bank independence seems to go hand-in-hand with lower inflation when the rule of law is strong. But, in the absence of rule of law, the relationship breaks down. Perhaps well-governed countries tend to produce well-run central banks, regardless of de jure independence.
Focusing on the United States, there’s a more fundamental difficulty. Legally, the Fed can’t be independent of politics. The Constitution vests the nation’s monetary powers in Congress. Congress created the Federal Reserve in 1913 and continues to oversee it, amending its authorizing statute more than 200 times. In global rankings of central bank independence, the Fed regularly places in the bottom quartile. This is a feature, not a bug. It would be a constitutional solecism to give the Fed immunity from Congressional control.
Defenders of Fed independence usually acknowledge Congress’s primacy but insist that central bankers need wide latitude to carry out day-to-day monetary policy. The legislature sets the Fed’s goals — think of the “dual mandate” of full employment and stable prices — but the Fed itself decides how best to achieve them. That impels an obvious question: how good is the Fed at its job?
For the last twenty years, the only honest answer is “pretty bad.” The Global Financial Crisis of 2007-8 happened on the Fed’s watch, and there’s a serious argument that the Fed not only failed to contain the damage, but sowed the seeds of the crisis in the first place. Its institutional response to the 2020 coronavirus crisis was initially promising, but it ultimately kept monetary policy too loose for too long, resulting in 40-year high inflation rates. It also ramped up its allocation of credit to politically favored causes — ironic, given how loudly central bankers complain about interference when elected officials ask it to account for itself. And, of course, the Fed’s forays into policy areas that have nothing to do with money and banking, such as climate change and racial equity, are well-known.
The Federal Reserve regularly flouts the rule of law. It needs more oversight, not less. That doesn’t mean that the president should have greater control over Fed personnel or policy. Watching Trump fire people is great television, but I suspect financial markets would be less than thrilled with that kind of governance.
What we need is to reassert the Fed’s accountability to Congress. Legislators can and should involve themselves more closely in the Fed’s operations. Specifically, they should once again amend the Federal Reserve Act to give the Fed a narrower objective, one that legislators can easily monitor and verify. The dual mandate is far too vague. Pick a specific dollar-denominated variable, such as the price level or nominal GDP, and force the Fed to achieve a stable growth path. When it fails, Congress can call Fed officials to account — and penalize high-ranking Fed officials who persistently err. It’s not enough for central bankers to receive an occasional tongue-lashing from a Congressional committee. If Fed officials can’t do their jobs well, they should lose them.
There are other reforms we should consider. Put the Fed on appropriations. Require it to get its funding for its activities other than monetary policy from Congress. No more self-financing. Close the discount window. The Fed isn’t any good at providing emergency loans anyway. Restrict the Fed’s regulatory activities. Focus its efforts on clear, simple, and efficacious rules, such as requiring private banks to maintain adequate capital against short-term liabilities.
All of these changes require less central bank independence, not more. Monetary technocrats ought not be judges in their own case. Yet that’s what central bank independence amounts to in practice. If reining in the Fed makes economists howl, so be it. Perhaps they will be surprised to learn their “smelly little orthodoxies” have no constitutional standing. The American people have a right to demand that their monetary institutions serve their interests.
