May 31, 2017

Fed Up With Congress

Scott Sumner

Ralph G. Hawtrey Chair of Monetary Policy

Patrick Horan

Program Manager
Summary

Congress needs to update the Federal Reserve's mandate.

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The Federal Reserve has control of day-to-day monetary policy in the United States, and its decisions are carefully scrutinized by journalists and policy professionals. But it is actually Congress that sets the basic parameters of monetary policy. Each time there is a significant change in Washington or in the markets, it's important to ask a few questions: What goals should the Fed be trying to achieve, and what tools are at its disposal?

That time has come. There are at least five things that need to be cleared up before the Fed can perform all of its functions.

When the Fed was created in 1913, the United States was still on the gold standard. At that time, the Fed's role was as a "lender of last resort" which could provide liquidity to the banking system during a crisis. There was no thought given to setting inflation targets, as the gold standard automatically tended to anchor the price level.

The gold standard was phased out between 1933 and 1971, and inflation accelerated sharply after the transition to fiat money, no longer backed by gold. Congress responded in 1977 with a new set of instructions – the so-called "dual mandate" of stable prices and high employment.

Traditionally, the Fed adjusts interest rates as its primary means of steering the economy. It lowers interest rates to boost spending during downturns, and raises interest rates to decrease spending during booms.

Since 2008, however, we have entered another new policy regime: the world of near-zero interest rates. The Fed's monetary policy options look quite different in light of these ultra-low rates, and it has responded with all sorts of unconventional policy initiatives. Unfortunately, its performance has been hamstrung by lingering uncertainty over its Congressional mandate.

Quite simply, the Fed has no idea what Congress wants it to do in this new era. This has led to policy timidity, which partly explains our slower-than-usual recovery from the Great Recession.

Here are the five questions that the Fed needs Congress to clarify:

First, what is the appropriate size of the Fed's balance sheet? Many central banks, including the Fed, have adopted "quantitative easing" at the zero interest rate boundary. This results in a very large Fed balance sheet, as it buys up large quantities of bonds such as long-term U.S. Treasuries and mortgage-backed securities. Should the Fed refrain from holding a large balance sheet? Are there limits to its size? What sorts of assets should the Fed purchase?

Second, should the Fed worry about capital losses in the price of its Treasury bond holdings (and possible bankruptcy)? Or should the Fed recognize that a decline in the value of its Treasury bonds is an equal gain for the Treasury, and hence a wash for the consolidated federal government balance sheet? The term "bankruptcy" certainly sounds scary, but it doesn't have much meaning within a branch of the federal government. Nonetheless, fear of having to ask Congress for a recapitalization may distort Fed decision-making.

Third, is negative interest on bank reserves (or "negative IOR") legal in the United States? Should it be? Negative IOR has been adopted in many foreign countries as a policy option when market interest rates fall to zero. Is this tool available to the Fed? One option might be to implement higher FDIC fees on bank reserves, which would encourage banks to hold less in reserves and move that money out into the economy through loans or the purchase of securities.

Fourth, should the Fed set an inflation target high enough to entirely avoid the zero interest rate problem? If not, does Congress have a preference as to which monetary policy tools it uses when rates are near zero? In addition to quantitative easing, should it use negative IOR? What about making commitments about the future course of monetary policy (what economists call "forward guidance")?

Finally, how should fiscal and monetary policy work together? Does Congress want the Fed to "do whatever it takes" to hit its macro targets (such as 2 percent inflation), or would Congress prefer to assist the Fed with fiscal stimulus when more spending is needed?

Right now, the Fed does not know the correct answer to any of these questions. Nor does it know whether Congress has a soft preference for any particular options.

Like the general public, Congress is not well-versed on all of these issues, and in many cases does not even have a coherent opinion. In that case, it is perfectly acceptable to delegate issues to the Fed. Or to call on the Fed to study the matter and issue a report to Congress. But, at the very least, that preference must be made explicit.

There is little doubt that the Fed could have provided a more transparent and credible response to the Great Recession if Congress had given it clear instructions on how to behave when interest rates fall to zero. Given that most economists expect to once again hit the zero bound in the next recession, now is the time for Congress to update the Fed's mandate.