Monetary Policy: Narrowing Discretion, Improving Outcomes
The Federal Reserve is allowed exceptional discretion in its conduct of monetary policy for the United States. Its Federal Open Market Committee (FOMC), the central planning body responsible for guiding the nation’s monetary policy, is by design insulated from direct political interference through a structure that includes lengthy office terms for its presidentially appointed members and the inclusion of regional Reserve Bank presidents who are appointed by their individual boards of directors. This operating framework is mostly seen as an advantage, helping to ensure sound policy, and enabling the Fed to achieve its dual mandate of maximum employment and stable, low inflation. However, the Fed’s record under this framework is mixed, with recurring episodes of inflation, financial crisis, recession, and unemployment. While the Fed requires a degree of discretion to carry out its mission, unrestricted discretion has repeatedly led to significant policy errors.
The following post outlines the Fed’s recent history of policy errors and suggests a policy framework that would improve both its performance and accountability. Part I notes the macro-policy errors, both monetary and supervisory, that have contributed to recurring episodes of inflation and financial crises. Part II introduces an operational framework that would narrow the Fed’s discretion over policy while allowing sufficient authority to conduct policy through the business cycle and achieve its mandates. Further, it would provide the Fed, at its discretion, the authority to conduct extraordinary policy, but for a defined period after which Congressional approval would be required.
Part I
A Recent History of Monetary Discretion
(“I believe the root cause of every financial crisis, the root cause, is flawed government policies.”- Hank Paulsen)
The United States abandoned the gold standard in 1971 and embraced the view that full discretion in the conduct of monetary policy was the best path forward, freeing the Fed to expand monetary policy programs with limited guardrails. Since then, the country has experienced growing deficits, repeated periods of asset and price inflation, massive increases in bank reserves and recurring banking crises. Following each crisis, the banking industry has been villainized and subjected to significant new rules to constrain its actions. However, the Fed has also played a role in these crises. With its wide authority to create bank reserves and influence interest rates, it contributed to repeated bouts of inflation and financial excess, leading to crisis and economic recession. Given this record, it seems appropriate to review its policy framework and consider narrowing its discretion.
Post 1971 Monetary Policy
Starting in late 1960s, the United States significantly expanded spending as it engaged in a war in Asia and a war on poverty in the U.S. Federal expenditures nearly tripled over the decade, and the national debt more than doubled. The Fed chose to support these initiatives, implementing monetary policy with a bias towards accommodation. As a result, the nation developed a debilitating annual inflation rate reaching more than 14 percent by 1980.
As inflation became imbedded in the economy, the public and the banking industry were convinced that prices of assets, goods and services would only increase with time. Banks lent freely, leveraging their balance sheets, convinced that the risk of loss was low. If a borrower was unable to repay, the bank would simply liquidate the increasingly inflated collateral such as retail and commercial real estate, oil, and land.
Finally, the FOMC, led by Paul Volcker, initiated an ultra-restrictive money policy, in which interest rates increased to more than 20 percent. The policy reduced inflation, but it wreaked havoc on the U.S economy, leading to the worst recession since the Great Depression. Stunned bank and thrift managers, as well as bank supervisors, were caught unprepared. Losses in real estate and energy rose dramatically, and commercial banks and savings and loan companies failed by the hundreds. The banking crisis became an economic crisis in which thousands of businesses that borrowed heavily during the boom failed, leading to a significant deflation in assets. The banking and financial system suffered major adjustments as the economy entered a deep recession.
In congressional hearings following these events, the banking industry was villainized as the cause of the crisis. Some banks did engage in unsafe practices, [1] but years of too low interest rates and persistent inflation allowed the industry to drop its guard against excess leverage and weak underwriting practices. In hopes of preventing a repeat crisis, significant legislation was passed narrowing the operating discretion of the banking industry. The Financial Institutions Reform and Recovery Act, for example, significantly expanded regulators’ enforcement authority to constrain bank activities and to impose civil monetary penalties on bank management. While banks were held to account, policymakers were not.
The Great Financial Crisis
A nearly identical pattern emerged around the Great Financial Crisis. Following a recession in 1999, the Fed eased monetary policy, repeatedly lowering the federal funds rate with an explicit promise that rates would remain low for “a considerable period.” In May 2003 the FOMC dropped the fed funds rate to the exceptionally low 1 percent where it remained for a year. During this time economic growth accelerated significantly, and speculative investment in real estate and other assets became the norm. Homeowners redeemed equity in their homes for cash to spend, and financial institutions were encouraged to lend on appreciated home values. As price inflation began to accelerate, eventually exceeding 5 percent, the Fed reversed policy, raising the fed funds rate from 1 percent in May 2004 to 5.25 percent in June 2006. This steep rise in rates shocked the U.S. financial system, leading to panic and a deep recession. Bankruptcies accelerated and the housing industry that had experienced an unprecedented rise in prices, collapsed. Banks, including the country’s largest, were not spared. Between 2008 and 2014 more than 500 banks that had leveraged their balance sheets failed or were bailed out.
Congress looked to assign blame, and bankers, who responded too willingly to policy incentives that the Fed created, received the bulk of it. Rather than limit the Fed’s discretion to print money and hold interest rates at exceptionally low levels, Congress imposed onerous legislation to control bank behavior on the mistaken notion that doing so would prevent future banking crises. The Dodd-Frank Act exceeded 2,000 pages, imposed significant and burdensome new laws on banks, and instructed the Fed and other banking agencies to write hundreds of rules, with the idea that such a crisis would not be repeated. For the banking industry, the cost of implementing these complex new rules was in some cases significant and is a contributing factor to the ongoing industry consolidation. [2]
Post Pandemic and Repeating the Pattern
Between the last time the federal government had a balanced budget, in 2001, and 2019 the federal debt grew from less than $6 trillion to nearly $23 trillion. In 2020, faced with the onslaught of the COVID-19 pandemic, the federal government doubled down on its spending, increasing annual expenditures 50 percent in that year to $6.5 trillion; and it continues to spend at that level today. Just as significantly, nearly all this new spending was funded with debt, causing the federal debt to reach $34 trillion at the end of 2023, or 120 percent of the nation’s gross domestic product (GDP).
The Fed has been an enabling partner in this spending and borrowing binge. In 2020 it restarted a quantitative easing (QE) program, using its powers to create reserves (base money) to purchase much of the government’s debt and to lower interest rates toward zero. By doing this, the Fed facilitated the growth of aggregate demand in the economy, as intended. However, it also immediately contributed to a significant increase in asset inflation, which by June 2022 metastasized into year-on-year price inflation of 9 percent as measured by the Consumer Price Index (CPI).
Monetary policy is a powerful and blunt instrument, and when policy is extreme, its effects are extreme. The federal government’s spending and the Fed’s policy accommodation, including QE and a policy rate near zero through 2022, raised the risk profile of the entire banking industry. Then, after inflation reached a level not seen in four decades, the Fed raised interest rates from less than .25 percent to 5.50 percent in less than 2 years.
While it is not yet clear how this will ultimately affect the economy, the effect on banking has been dramatic. For example, the industry reports unrealized losses from securities that exceed $600 billion. Notably, securities are only 25 percent of the banking industry’s total assets, meaning that significant potential additional losses remain embedded in balance sheets, implying downside risks to the industry and the economy.
A preview of how this could play out occurred in early 2023 with the unexpected failures of three large regional banks – Silicon Valley Bank, Signature Bank, and First Republic Bank. With these failures uninsured depositors suddenly found themselves at risk of losing billions of dollars in accounts at those banks and any others that might unexpectedly fail. This raised the specter of another financial crisis, causing the Treasury, Fed, and FDIC to intervene with bailouts and liquidity programs to stop the crisis from spreading throughout the economy. Questions of who was at fault were immediately raised, and bank management was dutifully identified and called to task. However, because bank depositors were uncertain of whether other banks might also fail, they quickly began to pull their deposits from regional banks. To stanch the panic, authorities declared the failures as systemic events, and effectively provided 100 percent deposit insurance for all depositors.
Once again, discretionary, highly accommodative monetary policy, conducted well beyond the pandemic increased the banking industry’s appetite for risk, inevitably exposing it and the public to heavy financial loss.
Can Bank Supervision Protect Against Money Policy Errors?
Given that monetary policy errors occur, can bank supervision serve as a backstop in assuring bank resilience and financial stability? There are two aspects of bank supervision that come into play in this regard. The first is micro-prudential supervision, with its focus on individual bank conduct and performance. This is a bottom-up approach to assure banks are run prudently. There can be a small number of banks that might fail, but the industry is kept fundamentally sound. In the case of Silicon Valley Bank, supervisors had identified severe weakness in its management, noting poor internal risk controls, excessive concentration in assets and uninsured deposits, and other related risks. While the quality of supervision in this instance can be questioned, such poor management was not endemic to the banking industry and should not have caused the systemic crisis that followed.
This threat of systemic crisis brings into focus the second dimension of supervision, macro-prudential, which sets forth industry safety standards designed to assure overall industry resilience. For example, these include rules requiring minimum loan-to-value ratios when underwriting loans or minimum capital standards to assure the banking industry is capable of absorbing losses should the economy enter a recession. There is substantial evidence that strong capital standards, for example, increase the industry’s resilience through the business cycle and that the cost-benefit trade-off favors such a mandate.[3]
However, macro-prudential supervision is implemented and enforced at the discretion of the bank supervisor, which is part of the same government as the monetary authority. When government and central bank policies are expansionary and encourage risk-taking, it is rare that bank supervisors impose macro policies in direct conflict with the national policy goals. During the growth phase of a credit cycle, loan-to-value and margin requirements that constrain lending often are deemphasized, enabling greater credit expansion accompanied by higher industry risk. For example, the Fed no longer requires banks to hold reserves on demand deposits that constrain bank growth. Also, although U.S. bank regulators have authority to impose counter-cyclical capital increases (buffers) on the industry as a precaution against future asset losses, this authority has yet to be used. Thus, even if the supervisor can moderate the effects of expansionary monetary policy, it seldom does. It is simply unrealistic to expect a central bank or central government to use one policy tool to stimulate an economy while simultaneously using another to constrain it.
Central banks cannot fully anticipate the degree or timing of the effects of their policy on the economy. It is therefore unreasonable to expect the industry or its supervisors to be better at this exercise than the monetary policy authority. For example, at the beginning of the 2008 financial crisis the Fed assured the public that the housing downturn would quickly reverse. Later, in 2021, it was confident that inflation was transitory and chose not to reverse policy to prevent a surge in price inflation. Once the Fed found it necessary to significantly increase interest rates, it failed to anticipate the full effects. Regulatory stress tests did not account for the possibility of interest rates increasing by a factor of 20 times in less than one year. No communications were made to have banks test their liquidity positions or to prepare for the effects of higher rates on asset quality. Only after banks suddenly failed and a liquidity crisis threatened did the Fed prepare its discount window to lend to banks that were solvent but suffering deposit flight.
Bank supervision can monitor and provide oversight into management practices of individual banks, but it is unable to consistently anticipate the effects of monetary policy on the banking industry, as history has repeatedly shown.
Part 2
Narrowing the Federal Reserve’s Monetary Policy Discretion
(“In the absence of a gold standard, there is no way to protect saving from confiscation through inflation.” - Alan Greenspan.)
Monetary policy is a primary source of systemic banking and economic crises, and bank supervision cannot insulate the industry or economy from significant macro-policy errors. Before Congress considers new rules for banks, it should turn its attention to the Fed and the framework within which the FOMC conducts monetary policy. While the framework should provide the central bank adequate discretion to achieve its dual mandate, such discretion should have boundaries beyond which its actions are subject to Congressional approval.
Placing boundaries around monetary policy is hardly a new idea. Since the Fed’s founding, economists have proposed different means to bring greater discipline to the policy process, but with little success. In the early 1960s, for example, Milton Friedman proposed that the growth rate of the money supply be set at a constant rate of growth, k-percent rule, to achieve money stability and avoid unwanted inflation or deflation.[4] John Taylor proposed a relatively simple formula that sets the fed funds rate to balance the trade-off between economic growth and the inflation rate.[5] Ben McCullum proposed to guide Fed policy by targeting the growth rate of nominal GDP.[6] While different in mechanics, the goal of each proposal is to develop monetary policy within a more consistent policy framework.
Critics of these rules, including the Fed, hold that such fixed rules for monetary policy fail to adequately recognize the unpredictability of economic events or unexpected crises. Such rules may work in calm periods, but in crisis they fail to allow monetary policymakers sufficient discretion to adequately address liquidity needs. (Also, the Fed does not fully control money growth, as measured for example as M2 or M3.) These objections have been accepted by Congress and the Fed continues to have extensive discretion. Thus, monetary policy continues without restraint or adequate accountability, and as result continues to repeat the same mistakes.
Discretion, Policy Rules, and Accountability
The FOMC is composed of individuals that possess knowledge and experience, and they should be afforded a degree of independence in conducting policy. However, discretion and independence does not assure sound policy. Concentrating such authority within a central committee, and without defined boundaries around its policy, has contributed to repeated policy errors. While no system is perfect, the country would be better served if the Fed’s monetary policy framework was designed using the following principles: 1) transparency, 2) sufficient discretion to conduct policy through an economic cycle, and 3) firm boundaries beyond which policy actions require Congressional approval.
Such a framework should start with how the FOMC determines the fed funds rate. The Fed, on a biannual basis, should provide to Congress its estimate of the long-term rate of interest consistent with stable prices and maximum employment, often referred to as the long-run natural rate of interest, r*.[7] Around this estimate, the FOMC would be permitted to set the federal funds rate within a predefined range. [8] For example, if r* plus the 2 percent inflation target is estimated to be 4.0 percent, the FOMC could be permitted to raise the federal funds rate to 6 percent or lower it to 2 percent over time. Thus, it could tighten or ease policy within a specific range as it judges necessary to meet its mandates.
Similarly, the Fed could be permitted to change the quantity of reserves available to banks – base money - through its open market operations. However, such changes should not vary by more than 1 percentage point of the economy’s average past 5- or 10- year growth rate of real GDP.[9] This rule would enable the Fed to provide liquidity consistent with the economy’s potential real growth rate but limit its discretion to expand bank reserves without exception.
What about exceptions? Should the economy suddenly experience economic or financial stress or liquidity shortfalls, the Fed should have discretion, upon notification to Congress, to adjust both interest rates and the money base as it judges necessary. However, there should be a set period, for example six months, beyond which it cannot exceed the preset rate and money base growth without Congressional approval. This could be done, for example, through a joint resolution of the House and Senate. To assure Congressional action is bipartisan, and to assure accountability to the American voter, approval of the resolution should require a super-majority to pass.
Such a framework would provide the Fed discretion to conduct policy as it pursues its mandates through the business cycle – to achieve low and stable inflation and maximum employment. Importantly, the framework also would provide that under exigent circumstances, the policy boundaries can be temporarily breeched to address an economic shock, or for longer periods with the approval of Congress. Thus, discretion is permitted but checks are provided to assure accountability for both the central bank and the Congress.
The objections to this proposal may be many but before it is dismissed, its benefits should be carefully weighed. For example, it has often been pointed out that the Fed was established to be independent of political forces to better assure that it can conduct policy in the long-run interest of the economy. But this ignores the fact that Congress is ultimately responsible for the monetary structure of the country and that it has the responsibility to oversee the Fed’s policy choices. Such objections also ignore that the Fed is already subject to political forces but in a far less transparent way than this proposal would provide. The Chair of the Fed meets privately with the Secretary of the Treasury to discuss policy and meets individually with members of Congress to keep them informed on various policy issues. In contrast, requiring the Fed to seek approval before engaging in long periods of exceptional policy actions, provides far greater transparency and makes it more accountable to Congress when taking policy outside established norms.
The framework outlined here also provides the Fed ample discretion to implement policy through most business cycles. The Fed retains meaningful discretion to conduct policy over time and without delay. It can rely on models such as the Taylor or McCullum rule to guide policy within the broad policy boundaries. The framework, however, limits the Fed’s discretion to engage in extreme or experimental policies without full disclosure to the Congress and the American people. Monetary policy affects the economy broadly, every business and individual in it. Placing boundaries around this discretion would serve to increase accountability both for the Fed and the nation’s elected officials, who ultimately are responsible for the country’s monetary system and its long-run success.
Conclusion
Financial panics and recessions are too often the product of poor fiscal and/or monetary policy, although they are too often attributed to the financial and banking industries, which are repeatedly subjected to added regulation under the belief that such rules will prevent future crises. In contrast, monetary policy’s contribution to these crises has been too easily dismissed, leading to repeated errors in policy.
While such a framework to restrict the Fed’s policy discretion would involve significant debate in setting parameters around key policy tools, as well as the best transition path toward its adoption, it would be well worth the effort as it would enhance policy outcomes and accountability.
[1] For example see: Penn Square Bank Failure, Hearings Before the Committee on Banking, Finance, and Urban Affairs, House of Representatives, Nineth-Seventh Congress, Second Session. Also, Continental Illinois National Bank: Staff Report to the Subcommittee on Financial Supervision, Regulation, and Insurance, of the Committee on Banking, Finance and Urban Affairs, House of Representatives, Ninety-Ninth Congress, First Session.
[2] Patrick McLaughlin, Oliver Sherouse, Mark Febrizio, M. Scott King, “Is Dodd Frank the Biggest Law Ever?” Journal of Financial Regulation 7, no. 1 (March 2021): 149-174.
[3] James Barth and Stephen Matteo Miller, “Benefits and Costs of a Higher Bank ‘Leverage Ratio’,” Journal of Financial Stability 38, (October 2018): 37-52.
[4] Milton Friedman, The Optimum Quantity of Money, Aldine Publishing Company, 1969.
[5] John B. Taylor, “Discretion versus policy rules in practice,” Carnegie-Rochester Conference Series on Public Policy Paper 39 (1993): 195-214.
[6] Bennett T. McCullum, “The Use of Policy Rules in Monetary Policy Analysis, Shadow Open Market Committee,” November 18, 2002.
[7] Federal Reserve policy is defined by and most often involves changes in interest rates, and whether it is a restrictive or accommodative policy is judged by how far its policy rate (Fed Funds rate) is above or below the estimated natural rate of interest, r*. The concept of the natural rate of interest is attributed to Knut Wicksell in his work entitled, “Interest and Prices.” (see Knut Wicksell. (1936) Interest and Prices: A Study of the Causes of Regulating the Value of Money. Sentry Press: New York, NY; see also, Claudio Borio, Navigating by r*: safe or hazardous?, OeNB workshop on “How to raise r*?”, September 15, 2021.)
[8] While r* is not directly observable, the Federal Reserve currently estimates its value on an on-going basis using established models; and to assure full transparency, it would be required to disclose these models and how it employs them.
[9] The Federal Reserve creates bank reserves, or base money, through open market operations, in which it buys or sells assets creating a new liability, reserves, owed to banks from whom it purchases the assets. Limiting the Federal Reserve’s ability to create reserves is consistent with Milton Friedman’s idea of increasing the money supply at a constant rate over time, sometimes referred to as Friedman’s k-percent rule.