Fighting the Fed

CAMBRIDGE – The US Federal Reserve is battling with members of Congress over a proposed law, the , that would require the Fed to use a formal rule to guide monetary policy. The Fed fears that the law would limit its independence, while the bill’s proponents argue that it would produce more predictable growth with low inflation. Who is right?

In order to understand the conflict, it is useful to compare the Fed’s independence with that of the Bank of England and the European Central Bank.

In Britain, the BoE has instrument independence but not target independence. The head of the Treasury sets a goal for the inflation rate and leaves it to the BoE to decide which policies will achieve that goal. If the target is missed by more than one percentage point on either side, the BoE’s governor must send an open letter to the head of the Treasury explaining why (and what the Bank proposes to do about it).

By contrast, the tasked the ECB with maintaining price stability, but left it free to provide its own operational definition. The ECB defined price stability to be annual inflation of less than but close to 2%. Given the structure of the European Monetary Union, there is no government oversight of the ECB, which thus has both target independence and instrument independence, though restrictions preclude specific policies.

The Fed is independent, but only in a very special sense: vis-à-vis the government’s executive branch. While the US president can instruct administrative agencies like the Commerce Department or the Treasury Department to take specific actions (as long as they do not conflict with valid legislation), the administration cannot tell the Fed how to manage interest rates, reserve requirements, or any other aspects of monetary policy.

But, though the Fed is independent of the White House, it is not independent of Congress. The Fed was created by Congressional legislation that now stipulates a dual mandate of price stability and maximum employment. It is up to the Fed to formulate operational definitions of these goals and the policies it will pursue to achieve them. The proposed legislation would affect both target and instrument independence.

The Fed decided to as a two percent annual inflation over the medium term of the price index of consumer expenditures. For the past 12 months, that rate of increase has been about 1.5%. While full employment has not been defined, many economists believe it is equivalent to an unemployment rate of about 5.5%. The was 6.1%.

Reflecting the fear that the Fed’s current policy of sustained low interest rates will lead to higher inflation, the law would require the Fed to adopt a formal procedure for setting its key short-term interest rate, the federal funds rate. More specifically, the law suggests a specific interest-rate rule (the Reference Policy Rule) while giving the Fed the opportunity to adopt a different rule if it explains to Congress why it prefers the alternative.