Dan Katz and Stephen Miran on Reforming the Federal Reserve’s Governance

Restructuring the terms of Fed board members and bolstering the relative power of reserves banks are just a few ways to improve the accountability and legitimacy of Fed governance.

Dan Katz and Stephen Miran are former senior advisors for the US Treasury Department and are currently adjunct fellows at the Manhattan Institute. Dan and Stephen have also written a new paper titled, *Reform the Federal Reserve’s Governance to Deliver Better Monetary Outcomes,* and they join Macro Musings to talk about this paper and the proposed reforms for the Federal Reserve outlined in it. Specifically, Dan, Steve, and David discuss the ever-expanding reach of the Fed, its role as debt manager and bank regulator, the current issue with the central bank’s personnel, and a lot more.

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Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Dan and Steve, welcome to the show.

Stephen Miran: Thank you so much for having us. It's a pleasure to be here.

Daniel Katz: It's great to be with you, David.

Beckworth: Well, It's great to have you on, and this was a really interesting paper. I've read a lot of papers on how to reform the Fed, but you brought in a truly novel idea that we'll spend some time on today. And I will just quickly summarize what I think is the key point in it, that you want to increase the power of the President over the Federal Reserve, but also increase the power of the regional banks as a balance. And you have this idea of money federalism, if I understood correctly, so it's very interesting. I look forward to jumping into that, but tell us a little bit about yourselves and how you guys came together to write this paper. What is the genesis of the paper?

Katz: Sure. So, Steve and I got to know each other when we were both working at the Treasury Department in 2020, as you mentioned. We became fast friends and frequent collaborators on a whole range of things. And, most recently, as we're both fellows here at the Manhattan Institute where we're recording, we had been thinking about, really, the conduct of monetary policy in recent years. And there's been a lot of work on specific thinking on forecasting errors and why inflation was more durable than expected, and so on and so forth. But we'd seen less thinking around the incentives that shape the Fed, generally, and so we wanted to think more deeply about the governance of the Fed, how that could have contributed to the monetary policy errors that we've seen in recent years, and how you might reform the system to deliver better monetary outcomes.

Miran: One thing that particularly struck us about the experience of the last few years is how little change had occurred at the Fed in the aftermath of the policy errors that we've seen. All of the folks who were involved in making policy mistakes generally continued in their jobs and even got promotions. And if you look at the new personnel appointments that happened to replace folks retiring, moving on, being promoted out, many of those people also didn't really have a shining record of correctly forecasting the inflation woes that we had. So, it got us thinking, what's wrong with the incentive structure for this system that it's not providing the negative feedback in order to get better monetary outcomes?

Beckworth: You highlight a number of developments that have occurred, as you mentioned. I would mention another one, just the politicization of the Fed in general. Like all federal agencies, it seems to become more and more politicized. Depending on who wins the election, it's going to swing to one direction or the other. It's important to keep the institution on solid ground, and you guys have some suggestions to help us get there. So, let's jump into your paper, and in the first part of your paper, you outline some of the problems, and let's take a look at them. You have a section called, “Lack of Accountability and Mandate Expansion Undermine the Fed's Effectiveness.” And the first issue you bring up is that the Fed is picking winners and losers, so walk us through that.

The Fed’s Issue of Picking Winners and Losers

Katz: Yes, so the specific issue of picking winners and losers in the paper and a range of other things we identify really go to powers that are better understood as fiscal rather than monetary. So, monetary policy, the setting of interest rates— when interest rates move up and down, they affect everyone. When you get into things like bank regulation that affects the allocation of credit or you get into things like the large-scale asset purchases under quantitative easing, the purchase of non-government obligations like agency securities, those have an impact on the allocation of credit in society. That, to us, is an inherently fiscal function. And so, the entry of the Fed into fiscal territory, in our view, has dragged it into the political process unnecessarily and polluted what should be its ability to conduct monetary policy free from political influence.

Miran: And one thing that I'd like to emphasize is that a lot of the issues that we're highlighting with the Fed where it's engaging in fiscal or political activities, for most of them, we're generally not trying to evaluate whether those are good or bad policies. For example, if the Fed is engaging in what they call a large-scale asset purchase and what market folks call QE, and they're buying mortgage-backed bonds— which are essentially funneled credit into the housing sector— that's ultimately picking winners and losers, because you're saying, "Okay, we want to preferentially protect the housing sector over other sectors of the economy, like manufacturing, or education, or something else, which is effectively an ultimately political decision. And we don't want to necessarily spend time evaluating whether that's a good policy or a bad policy. The housing market may require more attention from whatever economic reason.

Miran: But we do want to highlight that it's ultimately a political decision and, as such, should be made with political backing, as opposed to from a bunch of, essentially, bureaucrats who have limited ability, for the democratic bodies of Congress or the President, to oversee and to provide oversight of who, essentially, sometimes function as [or] would be philosopher kings. Whether it's a good policy or a bad policy, democracy, generally speaking, is a good thing. And if we don't need to give up democracy, we shouldn't do so.

Beckworth: So, let me go back to 2020 when you guys first met, and the Federal Reserve did a number of facilities during March, and they continued on for some time. And there were a number of them that they would justify on liquidity purposes, like commercial paper facility, primary dealer, even the currency swap lines. That was all about preserving the global dollar market system. Then, there were facilities that, I think, clearly fall under the credit camp, like the Main Street lending facilities, and maybe you could argue the municipal facility as well. But, in your view, is there a place for the liquidity facilities, and then you draw a line and no farther? Or, are those liquidity facilities, also, do you think, getting into credit allocation?

Miran: Yes, I think they are getting into credit allocation, and I think they're also getting into-- In general, with this crisis response stuff, we don't view crisis response as a bad thing, and I think that, in 13(3) facilities, as necessarily a bad thing that we need to tie the Fed's hands for. And many reform proposals for the Fed basically amount to removing capabilities, saying things like, "You can't do 13(3) emergency facilities. You can't do quantitative easing. You can't do large-scale asset purchases," and just remove those powers from the Fed altogether. Generally speaking, that's not an approach that we want to take, because we think the future is unpredictable, and the central bank needs to have tools to respond to shocks that I can't predict, nobody can predict. Nobody saw a pandemic coming, right?

Beckworth: Right.

Miran: That was an unpredictable event. It may be a rare event, but they happen, right?

Beckworth: Right.

Miran: Rare events occur, and the central bank needs to have a flexible and broad toolkit to respond to those rare events, or else you wind up with a depression, and a communist revolution, the things that central banks were invented to explicitly prevent. So, we don't want to remove the tools, we just want to provide more political oversight and accountability for those tools.

Katz: The other thing I would add is that I think the current system actually already recognizes that some of the Fed's crisis response capabilities are inherently political, right? That's why the Dodd-Frank reforms resulted in the Secretary of the Treasury needing to sign off on any 13(3) programs, right? There was a recognition that there should be political accountability for some of these programs. And so, again, we don't think these programs shouldn't exist. We just think if they're going to exist, you should have political accountability for them, and I would add, I think that if they're going to exist, they should be done and constructed in such a way that doesn't unnecessarily drag the Fed into political territory that impinges on its ability to conduct monetary policy free from political influence.

Beckworth: So, let's go to that area you touched on earlier, bank regulation. So, the Fed, it generates its own revenue, something that we'll talk about later in your proposal. It generates its own revenue, and it also oversees regulation of banks. Also, it's a major financial stability regulator, and it definitely creates some issues there, so maybe speak to that.

The Fed’s Role as Bank Regulator

Katz: Sure. It’s been interesting seeing the way that bank regulation has interplayed with the Fed in the post-crisis reforms, because if you go back to the history of Dodd-Frank, actually, early on in the reform discussions, the plan was for bank regulation to end up elsewhere, outside the Fed at some combination of the OCC and FDIC. But, lo and behold, at the end of the day, the Fed ended up with more power. In my view, there may be good technocratic, capacity-oriented arguments for having bank regulation at the Fed, given the wealth of experience of the people there and their high degree of skill, but I don't think the same arguments that apply to the need for independence in monetary policy apply to bank regulation. And you see this, for example, in the current fight over Basel III Endgame, which is dragging the Fed into a very ugly political fight.

Katz: And I don't know if you saw, but last week, Randy Quarles was on a panel at the Federalist Society on this issue, and his perspective that he articulated was that the Fed really needs to be different from some of the other regulatory agencies, and think more technocratically, and be less intricately bound up in the political process. I want to be clear, I have enormous respect for Randy Quarles and deeply admire him, but I think he's just wrong about this. I think bank regulation is an inherently fiscal function, and therefore, it should be in a body that's politically accountable and that doesn't unnecessarily impinge on the Fed's ability to operate independently with respect to monetary policy.

Beckworth: Do you think that the funding part also is important there, that they don't have to go to Congress to get appropriations to do the role of bank regulator?

Miran: Oh, yes, it absolutely is. The fact that they don't have to go to Congress to get appropriations enables them to engage in a wide variety of activities that Congress might not necessarily support. Bank regulation is part of that, but also an entry into— and maybe we'll talk about this in a little bit— Entry into all sorts of politicized debates, like climate and other things, are things that Congress might not necessarily appropriate money for, for the Fed to engage in broad-based research agendas in certain areas of the economics literature. And the fact that the Federal Reserve doesn't have to get money from Congress to pursue its activities means that they can basically go into any direction that they want to, so long as they don't feel that Congress is ever going to legislate against it.

Beckworth: I think that's a great point, this issue of democratic legitimacy. Having the support of the public is very important. That's the only way to preserve independence, to be technocratic. Do we tighten? Do we not tighten? You want to preserve that, and I like that thrust of your paper. And it strikes me that the Federal Reserve has more and more on its plate; monetary policy, bank regulation, payment systems. That's FedNow now set up, right? It's doing so much. I just got to think that Jay Powell, when he wakes up in the morning, he has so many issues to think through. [For] one person, that's got to be a Herculean task to be a successful Fed chair, [and then] politics on top of that.

Beckworth: How do you navigate nominations? How do you navigate different presidents? It just seems to be a lot to ask one agency, and I wonder if, to some extent, the Fed's success in the past is why it's been given more and more to do, because maybe Congress isn't doing its job and maybe more pressure is being put on the Fed. For example, in 2020, those facilities should have been facilities set up by Congress. I know Congress did the CARES Act, authorized the Fed to do things, but I agree. A lot of that was fiscal policy, right? If we had maybe a more functional Congress, it would do more, or some other federal agency. What do you think about the trend where the Fed is doing more and more and more?

The Ever-Expanding Reach of the Fed

Miran: Oh, yes, I think that's absolutely the case. The fact that the Fed had, for many decades, successfully executed policy pretty much across the suite of policy domains led it to be perceived as this highly qualified, highly competent, highly technocratic organization that government could give more and more responsibilities to. And so, those responsibilities bloom and blossom and expand.

Miran: The fact that the Fed is sometimes perceived as being “the only game in town” means that the Fed feels more comfortable to take on those responsibilities, because they feel that if they don't do them, no one else will. But it also creates an environment in which Congress does not, because Congress feels comfortable knowing that the outcome will be okay, because the Fed will take care of it, right? So, there's an element of moral hazard at play, because Congress feels [that] sometimes it doesn't have to tackle an issue, because it knows the Fed will pursue it, right? Then, the Fed pursues it because they know Congress won't, and if both sides [could] just stop doing this, then you could break that cycle.

Katz: Yes, [and] the other dynamic I would also add to the mix is that the accretion of more and more responsibilities at the Fed, and the accretion of more and more capabilities to discharge those responsibilities, also create this tendency towards increasing technocratic focus, a view, generally, that the Fed is omniscient and can do a great job predicting the future, which I think is generally not that helpful for their policymaking, not just in monetary policy, but in bank regulation.

Katz: And combined with the points that Steve just emphasized with respect to Congress, I think it creates this one-way ratchet where Congress, in some respects, is able to discharge its responsibility for actually making policy. Take bank regulation, for example. What we have now is Congress essentially delegating most of its authority to the Federal Reserve, and that creates an incentive for the Fed to engage in highly technocratic bank regulation, which may actually not be the optimal system if you went back and redesigned the policy from the ground up. In fact, I have a column coming out this week with your colleague, Tom Hoenig , from the Mercatus Center, on some of these topics and the general problems with an excessive faith in technocratic capabilities when it comes to bank regulation and arguing for a return to a simpler set of rules.

Miran: When we talk about democratic accountability and political accountability, we don't purely mean the ability of democratically-elected representatives, whether the Congress or the President, to choose the personnel at the Federal Reserve. That's not the only thing we mean. There's much more to it than that. And so, if you think about, for example, the Freedom of Information Act, FOIA – the process whereby citizens and journalists can get access to the machinery behind the decisions that a governmental body is making and find out what calculations were made, what analysis was done, what deliberations were held, what tradeoffs were considered— That's a major tool of democracy and a major tool of democratic transparency and the well-functioning of Western liberalism.

Miran: The Federal Reserve, as it accumulates more and more powers, whether in crisis fighting or bank regulation, to the extent that any of those functions can be placed in one of the reserve banks as opposed to at the board, they can avoid the light of day via the FOIA process, because the FOIA process applies only to public entities, and public agencies, governmental agencies. And the reserve banks, as I'm sure we'll talk about, are actually private corporations owned by their local banking systems. And so, to the extent that more and more powers keep accumulating to the Fed, they wind up going behind this FOIA shield that's the private ownership structure of the reserve banks, and that's unlike what would happen if these powers were held at other agencies like Treasury, or OCC, or Justice, or anywhere else in the Executive Branch.

Beckworth: Yes, you bring to mind the issue of Fed Master Accounts, which, supposedly, the local regional Fed banks determined that we have some reason to believe that the Board of Governors is also putting its thumb on the scales, and the recent case of FinTechs trying to get access to Fed Master Accounts— Another issue on the plate of the Fed that they have to deal with which is very political. It would be great to have more transparency in how that was done. Although, we did get a law that was passed that, so they have to disclose a database of who has Fed Master Accounts. But, again, it goes to this responsibility to [inaudible] on the Federal Reserve.

Beckworth: One other observation I want to throw at you guys— and this, to me, is an important one in terms of who manages the public debt, who manages our national debt, and that is a responsibility traditionally given to the Treasury Department— but the Federal Reserve, as far as the balance sheet [is concerned], has effectively become a debt manager. At least a quarter to 30 percent or so of the public debt is held by the Fed. So, they're effectively determining some of the duration, some of the average maturity on the debt. Is that something you guys also consider as an important issue to be debated?

The Fed as a Debt Manager

Miran: Absolutely, 100%. And so, one of the criticisms of LSAPs, QE, [and] Fed balance sheet expansions as a form of providing additional stimulus to the economy— when this first was introduced in the aftermath of the financial crisis, 2009, 2010, was that they sort of break down the wall between monetary policy and fiscal policy. Because what the Fed does when it engages in a large balance sheet expansion is it, rather than its normal operations of buying and selling short-term Treasury bills that have very little interest rate risk, very little duration, they bought longer-term Treasury securities, longer-term mortgage agency-backed securities.

Miran: What that did was to basically change the amount of interest rate risk that exists out there that the public has to hold. Interest rate risk is very powerful, and if you ask the public to hold more interest rate risk, they have less tolerance to hold other risk, like equities, like credit, like other forms of risky assets. If you ask the public to hold less interest rate risk because the Federal Reserve takes some of it away, the public has more room to hold equity risk, to hold credit risk, to hold other forms of risk and support other forms of risk-taking activity. So, when the Fed buys a huge amount of Treasury bonds, longer-term Treasury bonds, [and] takes them out of circulation, they basically push up all risky asset prices, because the market now has more risk-taking capacity to absorb equity risk, credit risk, and other things.

Miran: That's what the Fed was trying to do when it started doing this QE program. Economists, as you know, call it the portfolio balance channel, and that theoretically provides stimulus to the economy and boosts things. However, it impedes on fiscal functions, because the Fed is explicitly changing the distribution of maturity risk that's out there in the market, but the selection of the maturity profile of the public debt is a core fiscal function. That is a core, core, core fiscal responsibility of the Treasury Department. So, the Fed is effectively impeding on what ought to be fiscal decisions when it starts buying longer term debt.

Miran: Now, the problem that we come to today is that once the barrier between monetary and fiscal policy breaks down, it can be crossed as it was during the QE years by the Fed engaging in fiscal policy, but it can also be crossed in the other direction, that the Treasury can engage in monetary policy. And so, what's been happening for the last 18 months is that the Fed has been doing the opposite of LSAPs, the opposite of QE, [and] they've been allowing their balance sheet to roll down in size as their Treasury holdings mature. They don't replace them on their balance sheet. Market people call this QT, quantitative tightening.

Miran: This has the opposite effect of providing more duration risk into the market, more interest rate risk into the market, which then should theoretically lower the market's ability to absorb other forms of risk. There have been periods in which Treasury has effectively sterilized the Fed's QT by offsetting the Fed's increased supply of duration into the market with reduced supply, by shortening the maturity profile of their issuance, issuing more bills instead of bonds. And so, to make this a little bit more concrete, during the period of monetary tightening for the last couple of years, the Fed has been injecting more bonds into the market by allowing them to roll off its balance sheet, right? 

Miran: Treasury offset this by issuing fewer bonds and issuing more bills, more very short-term instruments and fewer long-term instruments. And so, once you break down the barrier between monetary policy and fiscal policy, it can be crossed in both directions. And ten years ago, the Fed was crossing it from monetary into setting fiscal policy, and now what you have is you have Treasury effectively shortening the duration profile of their issuance for the last year or so, so that Treasury can cross over the barrier and be setting monetary policy, effectively neutralizing quantitative tightening, which is a significant portion of the overall amount of monetary tightening that the Fed has provided, in order to try and control inflation.

Katz: Yes, if you operate from the perspective that the Fed needs to take, into account, fiscal policy and setting monetary policy, and the Fed treats the composition of US debt as monetary policy, then as the Treasury decreases the supply of interest rate risk in the system, in theory, the Fed should respond to that and take that into account in the setting of monetary policy and allow even more duration to mature off its balance sheet. And maybe it should even actively sell longer-term securities off of its balance sheet, to counteract the removal of interest rate risk from the system that the Treasury is engaged in. And, again, putting the Fed in the position of having to engage in these questions about whether it should be offsetting Treasury's effects on decisions about the supply of US debt— it's just really not helpful to preserving the Fed's independence to set interest rates.

Beckworth: Now, let me play devil's advocate here, because we've been piling it on the Fed pretty extensively so far, and I want to be fair to them. They would say that in the zero lower bound environment, that they have to do this, that their policy tools are exhausted, right? We just said that we don't want them to be politicized, maybe buying up equities. So, they're going to start buying up a lot more bonds. Their hands are tied. What else can they do in a zero lower bound environment? Now, to be clear, that wasn't the case in 2022, so I think, clearly, they made some mistakes there. But, say, 2008 or maybe 2013— What would you say to them in those situations, where they feel that their hands are tied, fiscal policy is not doing enough, so we've got to do something or it could get worse?

What Should the Fed Do in a Zero Lower Bound Environment?

Miran: I would say that I think that a lot of that attitude comes from how they've chosen to interpret their mandate in a way that potentially goes beyond what Congress assigned to them. I've long argued that it's extremely difficult to measure inflation. Inflation is an abstraction. The general price level is an abstraction. It doesn't exist. You can grab a barrel of oil, you can grab a pound of sugar, [but] you can't grab the general price level. You have to construct it.

Miran: The way that it's constructed involves a large number of methodological choices made by government statisticians who do heroic work trying to accomplish what's an impossible task, but how do you accommodate housing and calculate owners’ equivalent rents? How do you adjust for new product categories? How do you adjust for technological improvements? How do you choose weighting indices? What prices do you measure, consumer prices, producer prices, a mixture of them? Do you impute prices for overall consumption or only out-of-pocket expenditures?

Miran: There's a very wide variety of choices that you have to make when you construct inflation and, therefore, the measurement error is enormous. And so, if you go back and you look at a real crisis period, like 2009 or the first half of 2020, you can say, "Yes, it's absolutely justified to be engaging in emergency activities, because it's a real emergency.” But by the time you get to 2012, by the time you get to even late 2020 or early 2021, it's very clear that we're no longer in an absolute crisis.

Miran: And you look at inflation, and inflation is 1.7 percent or something, as it was for much of the 2010s. They're missing their inflation target by about 30 basis points to the downside. From my perspective, that's absolute noise. And so, the idea that the Fed is going to adopt an emergency posture, because they're missing their inflation target by what's essentially noise, strikes me as rather silly and the source of a great deal of problems that we've had. The measurement error almost certainly significantly dwarfs that. And so, emergency policies are important, and as I said before, we crafted a lot of our proposals to try and preserve the flexibility to use emergency policies, but they should only be invoked for actual emergencies.

Katz: I'm very sympathetic to the position that the Fed and lots of other central banks found themselves in, in the post-crisis era. People go into public service to try to make a difference and create better outcomes for their fellow citizens. And so, it must have been enormously frustrating that there was seemingly no help from fiscal policy and no easy solutions that could result in a faster recovery. But I think it's generally a mistake to then take the view that, "Well, if no one else is going to do it, central banks are the only game in town," and therefore, to do anything that you had in your power to try to make the system better. I think that this is generally emblematic of a mindset in central banking that has actually proven to be not so helpful, to think that central banks are masters of the universe and should exhaust any power they could conceivably have to try to make things better.

Katz: I think that that level of institutional hubris, if you call it, is how you get things like flexible average inflation targeting in 2020, which as Steve just articulated with respect to the measurement of inflation— the idea that you could properly measure a 30 basis point undershoot of inflation and also that you could properly control an overshoot so as to make up for those past undershoots, I think, is revealing of an institutional culture that places too much faith in its own technocratic expertise. I think that you would arguably see less of that kind of institutional culture if you had more accountability in the system that prevented things from getting too far away from the narrow mandate.

Beckworth: One of the other ones that I want to mention before we move on to your actual proposed reforms is personnel. You have a section titled “Personnel is Policy.” What is the issue there?

Personnel is Policy: The Issue with Fed Personnel

Katz: So, I would really connect this issue around personnel to the structure of the Fed, generally, and the accountability. And so, in theory— given the very limited accountability that the Fed has today— if there was a partisan political actor inside the Fed, they could actually, potentially do a lot of damage, because there aren't many accountability mechanisms to actually check that. But it doesn't even need to be the case that there's an explicitly partisan actor who's pursuing explicitly partisan ends.

Katz: For example, think about Austan Goolsbee, whose rhetoric since joining the Fed, I really admire. He is very clear every single time he's in front of a camera that politics are not part of the discussion, and that his only guiding light is the dual mandate. And he's surely correct that politics are not discussed in the boardroom, and I'm sure we'll see that when the transcripts get released, but can anyone really believe that you can go from being a campaign surrogate— as he was described— for the Biden campaign, to being entirely nonpartisan, overnight?

Katz: No, that's simply not plausible, and, to be clear, that's not anyone's fault. This is simply unavoidable. This is natural, right? Individuals necessarily have political preferences, and that's probably particularly true of immensely talented economists and policymakers that end up on the Fed board. And so, in our opinion, the better course isn't to pretend that those preferences don't exist. The better course is to acknowledge that they do exist, and to instead try to check the potential that those preferences pollute the monetary policy process with structural features that, in our opinion, can enhance the performance of the FOMC, as well as its independence.

Beckworth: I like that. There are always going to be political preferences, for every governor, every president. I think Bernanke was at the White House CEA, then he went to the Board of Governors. And, dare I say, Alan Greenspan, he was closely tied to the Nixon administration, and many Democrats hated when he would go before Congress, and he would talk about monetary policy, and then he’d talk about the deficit. It drove them crazy. So, I think it's always there.

Beckworth: Now, I do think, though, it's probably more pronounced now than before, because everything's gotten so much more politicized. So, you guys have some good suggestions on how to recognize that reality. So, let's move into that. Let's talk about the reform proposals you outlined. So, many of the things that we've touched on, probably some of the listeners or many of the listeners are familiar with, but you have some really novel ways to deal with this issue. So, let's start with the personnel reform, because we just were talking about this. What do you recommend we do there?

Options for Personnel Reform at the Fed

Katz: Sure. So, I also just want to state at the very top, before we get into the nitty-gritty of the explicit reforms, which is that we do not reject the idea of central bank independence, generally. We actually, really think it's important for the central bank to have the insulation from the day-to-day political process to make good decisions on monetary policy, which really just means being able to raise interest rates when it's politically unpopular to do. It's important. There's a reason why it exists. But while independence is necessary for good monetary policy, it's not sufficient. In our view, you still need a range of other features of the Fed's institutional design to encourage it to make better decisions. And so, that's really what we're trying to get at with our reform proposals. It's how you can incentivize better decision-making in the room to create better monetary policy outcomes and also not risk losing independence.

Miran: So, when it comes to personnel reforms, there's a few things that we think are important. First of all, we think that it's important to reform the term limits, which, at 14 years, are far too long, because they're almost never served out. In fact, only a couple of governors have ever actually, really served out their full term, one of whom was Alan Greenspan. Now, what that does is it provides perverse incentives to end one's term, to resign prematurely, at an opportune moment. In the same way that Supreme Court justices are encouraged to retire when there will be a sympathetic President and Senate to replace them with an ideologically like-minded next justice.

Miran: In the same way, Fed governors are incentivized to time their exits such that the President can replace them with a sympathetically minded successor. We saw that, perhaps, with what happened with Vice Chair Brainard, Lael Brainard, moving to [become] the NEC director earlier last year. But you see that more broadly, that the terms are very long, right? So, we need to shorten the terms to remove that incentive so that governors can serve out a presidential term, the length of two presidential terms, but not timing their exit in a way that allows them to trade policy decisions at the Fed for allowing the President to choose a sympathetic successor. 

Miran: We also think that it's important to close the revolving door between the Fed and the White House. So, once one leaves the Federal Reserve, one should be prohibited from taking a role in the Executive Branch for a period of time. That will remove incentives for Fed governors to perform in a way that a president will find pleasing in exchange for plumb jobs in the White House and other parts of the government and Treasury after they leave their term. You have to remove the incentives that Fed officials have for trying to please a sitting president.

Beckworth: So, you're recommending eight-year terms, and then, I believe you said a four-year window between being at the Board and then serving in the Executive Branch. Is that right?

Katz: Yes, that's right. So, eight-year terms, and then a four-year prohibition on serving on the Executive Branch. Then, the next personnel reform at the Board level that we're sketching out is probably the one that's most controversial and gotten the most attention, which is the idea that the president should be able to remove members of the Board at will. The reason why we approach this issue is because the reality is that central bank independence is, to some degree, in tension with the US constitutional design. And the way that central bank independence has been operationalized in the US, and across other government agencies, is that Congress has set up these agencies, it's given them mandates, and then it has given the individuals who exercise authority some degree of protection from removal by the president.

Katz: But the Supreme Court, in recent years, has actually been casting doubt on the constitutionality of this system. We've seen, just in recent years, a CFPB case and an FHFA case where the Supreme Court has found that removal protections, in the instance of those agencies, were actually unconstitutional, and the president needs to be able to fire those individuals at will in order to be able to exercise authority over the Executive Branch. Now, there are ways to distinguish other independent agencies like the SEC, which is multi-member, or the Fed, which is also multi-member, from the CFPB and the FHFA, but it's entirely possible that in the coming years, the Supreme Court is going to strike down these removal protections, and so you're going to end up in a place that we're recommending anyway.

Katz: And that's why the real crux of our FOMC reforms are so important, because if the Supreme Court did strike down removal protections, you would end up with a president who is able to completely dominate the FOMC from the start. And so, the real crux of our FOMC reforms is to make the reserve banks able to vote at every meeting in the FOMC. And so, the balance of power on the FOMC will move away from being dominated by the DC-based Board of Governors, and instead the majority of the FOMC will be made up by the reserve banks who bring what we view as a critical perspective into the monetary policy process, and historically have also been the source for much of the rich debate at the FOMC that's needed to effectively make monetary policy. And so, we actually view it as quite distressing, the decline in dissents that we've seen at the FOMC in recent years, which, in our judgment, have contributed to some of the policy errors that we've seen.

Beckworth: Some of the groupthink. So, you would have the balance of power at the FOMC go from 7 governors to 5 presidents and take that and flip it, so it's 12 presidents and then the governors. So, 12:7, is that right? That's where you'd end up?

Miran: That's where we'd end up, but the present balance of 7:5 is more like 8:4, because the New York Fed-

Beckworth: Fair enough.

Miran: -President is effectively a part of the Board in terms of policy voting patterns, if not as a legal matter. The overall vision that we have is one of saying, okay, what is central bank independence? Is central bank independence an end in itself, or is it a means to another end, which is good policy outcomes, good outcomes for the American people? We think it's the latter, and we think most other people would agree that central bank independence is a means towards good policy outcomes, not something worth pursuing for its own sake.

Miran: So, if that's the case, then you have to ask, how can we pursue these outcomes better? And I think it's critical to ask the question of, what is the cost of pure independence? And the cost is one of, as we were talking [about] before, eroding democratic norms. And so, what we want is to find a way to bring back in some democracies, bring back in some democratic norms into the system, but isolate the Fed from day-to-day political pressures by using a tool that served America so well for its entire history, of federalism. So, we consider our system to be one that we call monetary federalism, whereby you can increase political oversight over the Board of Governors, but dilute the power of the Board of Governors by making the reserve banks vote at every FOMC meeting. And so, while you can increase the control of the president over the Board by just making these positions at will, as Dan said before, they effectively are at will anyway.

Miran: I don't think anybody really has any doubt that, in a fight between the president and a Fed governor, that the Supreme Court would side with the Fed governor. That's quite unlikely, I would say. But by recognizing that, you can provide some democratic accountability and political oversight in the same way [that] every other agency in every other part of the Executive Branch has, but you can balance that against increased power for other parts of the system that the president has no control over.

Beckworth: And that's what's unique about your proposal, because I've seen a lot of Fed reform proposals in my role here at the Mercatus Center, in the Monetary Policy Program. Many of them will say, "Let's empower the regional banks," or they'll say, "Let's get rid of the regional banks and make the Board of Governors bigger. Let's just bring them all in, so it's one of the other,” but you're doing both in a way that still preserves this democratic legitimacy, accountability, and that the president has that willpower over the governors, but you empower all 12 presidents to vote at the FOMC.

Beckworth: Now, I think, key to your proposal working, though, is the rest of your proposal, which we haven't talked about, and that is how these presidents get selected. Because even right now, there's talk about— You mentioned Austan Goolsbee. There was some talk that maybe there was some influence from above from the Board of Governors. So, you guys have a proposal that would make the president selection more robust, should I say.

Making the Fed President Selection Process More Robust

Miran: Yes, so, the regional reserve banks— which may surprise some people— but the regional reserve banks, like we mentioned before, they're not public institutions. They're private institutions, and they're owned by the regional banking system. So, the private banks, in each district, own the Fed, which means that these banks own their own regulators, which is a bizarre institutional arrangement, but that's the way it is. And then the boards of directors of each of these regional Federal Reserve banks are comprised of a variety of directors. 

Miran: Class A directors come from the banking system, meaning that bank executives sit on the board of the reserve bank that they own, which regulates them, which, again, is a bizarre conflict of interest. Then, the other directors are a variety of community participants, nonprofits, activists. But some of these nonprofits and activists, they have definite axes when it comes to monetary policy. They can be labor union heads. The AFL-CIO head sits on the board of three reserve banks and is, I think, the President of the Kansas City [Fed] Board of Directors.

Beckworth: That was really interesting, to read that in your paper.

Miran: You have affordable housing activists who clearly have an axe when it comes to credit allocation to the housing sector, who clearly have an axe to grind when it comes to where interest rates should be for building affordable housing. You have other directors who run organizations whose mission it is to decolonize the United States. It's all sorts of oddballs on these boards of directors that don't necessarily make sense from an institutional arrangement.

Miran: So, what we want to do is that, first, we want to nationalize these reserve banks so that they're not owned by the banking system and not controlled by special interests. We want their boards of directors— rather than being selected by the banks and the Board of Governors as they are at present— we want their boards of directors to be selected by the state governors in each district. So, what we want to do is, we want to provide democratic legitimacy, for the first time, to the regional reserve bank system, because, at present, there's precious little democratic legitimacy to the New York Fed, or the San Francisco Fed, or the Dallas Fed, or any of the rest of them. They're creatures owned by the banking system. The boards of directors are chosen by the banks and the Washington-based Federal Reserve Board of Governors, and their leadership is chosen by those forces.

Miran: So, we want the boards of directors of these regional banks to be chosen by the state governors, again, who are democratically elected, in each district. Then, we want those boards of directors to choose the presidents of each of the reserve banks, in contrast to how it's been done in recent years, in which the Washington-based Board of Governors of the Federal Reserve give the reserve banks a short list of candidates to choose from, and thereby pressure the reserve bank boards’ directors, who are, as I said before, local bank executives and non-profit activists, who give them some pressure to choose their reserve bank leaders from the Board of Governors. And that's how you wind up with someone like President Goolsbee.

Katz: I want to just contextualize this reform around the reserve banks with our broader goal to both incentivize better decision-making at the FOMC and also to protect it from political influence. On the political influence side, given the reforms to the board that we've suggested, presumably the President of the United States, members of his party, or people who are sympathetic to his view will dominate the Board of Governors.

Katz: But then, with the reserve banks, you're going to have a mix of political constituencies that the reserve banks need to be subject to, in part because national parties are not completely uniform. They're best understood as a collection of political constituencies. And so, you'll necessarily have a broader perspective given the broad range of interests that we have around our country. Also, we have representation from both political parties throughout state governments around the country. And so, you should have some degree of political diversity injected into the FOMC if you have the reserve bank presidents selected by state officials, balancing the president selection at the Board of Governors level. 

Katz: So, that takes care of independence. But also, on the effectiveness side, we think that this concept of federalism is essential to getting better monetary policy decision-making at the FOMC level. So, we fully expect having important differentiated perspectives, that are not beholden to the Board of Governors, in the room at the FOMC to enhance the quality of debate at the FOMC, and we would hope, also, deliver better monetary policy outcomes.

Miran: There hasn't been a dissent at the Board of Governors in 20 years. Regional presidents dissent occasionally, but they're irrelevant from a policy-setting perspective, because the Board of Governors, as we said before, dominates policy eight to four. And so, they can look the other way whenever a regional president dissents and just move on with whatever policy they want to accomplish.

Miran: That's crazy, right? Economics is hard. Forecasting is hard. What's the right policy is like an impossible question to answer. It's crazy that there's just such unanimity and uniformity and block voting. It's completely unhealthy from a decision-making perspective. You get groupthink. You get comfortable consensus, and people feeling comfortable being wrong in consensus because everyone else is wrong too. And you get lack of accountability because, “everyone's wrong so it wasn't my fault.”

Miran: You need a healthy debate. You need healthy disagreement. You need healthy arguments. You need a variety of views. And you don't get that with uniformity. You don't get that with block voting and lack of dissents. And so, we want to introduce a system in which there is a lot more dissent, in which there is a lot more debate, open debate, about what policy should be, because I think it's very difficult to say what's the right policy.

Miran: The idea that everyone is in agreement all of the time makes no sense. I think if you look at a system like the Bank of England, where the governor is not only once in a while, but, with some frequency, in the minority, is a much healthier intellectual environment, I think, to try and arrive at good policy, and, at the very least, convince the American people that the question at hand was debated and examined from all possible sides instead of blithely shunting away dissent and saying, "Oh, we were surprised by inflation. Nobody thought it could possibly have happened." Well, nobody thought it could possibly have happened, because there was no disagreement, there was no dissent, [and] there was no open conversation about it.

Beckworth: Let me play devil's advocate again on the Fed's behalf, because we've been piling on again. I think Jay Powell would say, in response to that observation, that there is debate, it's just not open. You said open debate, that behind closed doors they're maybe negotiating, “should we do a rate hike or not?” But they want to have the appearance of unified support, but that still leads to a problem, I think. If you're worried that you can't speak your mind— Clearly we saw, in 2022, this delay in getting the rate hikes going suggests that there is still a lack of diversity and some groupthink going on. So, I think it's a fair point. Let me circle back, though, to the proposal for the regional banks. I think that's important, and, again, very interesting. I love this term, monetary federalism. I've never seen it before until I read your paper. In fact, is this original to your paper, this term?

Katz: Well, we made it up, so that's probably the reason why you haven't seen it before.

Beckworth: Okay, the answer is yes.

Miran: It's possible someone else used it before, and that we're not aware of it.

Beckworth: Own it, own monetary federalism. I like it a lot. And, again, it's a key part of your paper. You're going to empower the president and the Board of Governors, but you're also going to empower the regional banks so you have monetary federalism. Now, the issue that comes up is that you have certain Federal Reserve districts that are just ridiculously spaced apart. The San Francisco Fed basically owns half of America. So, you do talk about in your paper [that] maybe some adjustments need to be made along those dimensions.

Miran: Yes, absolutely. I completely agree with your description of our project overall. What we're trying to do is to simultaneously maximize democracy and good policy outcomes, which requires some independence. Whereas, we think everyone else heretofore has thought merely about good policy outcomes and totally thrown democracy out the window. So, I completely agree with that description.

Miran: But when it comes to the map, yes, I think you'll have to adjust the map. Look, we had 20 pages and 12,000 words or whatever, and it was as long as it was. I'm not a cartographer. We recognize the issues out there, and I think that if you were going to seriously draft legislation to try and implement some of our reform agenda, [then], absolutely, you'd think about making the map more representative of the modern economy and the modern distribution of population across the country, no question about it. It was just a matter of space constraints.

Beckworth: Let me circle back briefly to my pushback about debate, that maybe there is debate behind the scenes. I didn't give you a chance to respond to it. I'm just curious, any thoughts on the possibility of there being debate behind the scenes versus open debate?

The Nature of Debate at the Fed

Katz: I certainly hope that there is debate behind the scenes, but I would say that projecting consensus outwardly is misleading to the public and may create bad reactions in the marketplace and misunderstandings of where the Fed is actually at. I think that hypothesis would kind of play out in the way that we've seen monetary policy evolve over the last few years. We saw the Fed adopt flexible average inflation targeting in 2020— unilaterally, without consulting Congress, might I add.

Katz: Then, we get the Fed, in 2021, projecting that inflation is going to be transitory. 2022 brings us the Volcker pivot, [with] Chairman Powell saying quite openly that he was willing to risk a recession to restore price stability. Then, at the end of last year, we get mission accomplished on inflation and a pivot to signaling cuts. And now, we might actually be headed in the opposite direction now that it looks like inflation may be more durable than we had imagined. And so, I would say that projecting too much consensus and false degrees of certainty about the future actually enable that kind of oscillation of monetary policy, which is not particularly helpful.

Beckworth: So, even if they are having these debates behind the scenes, the appearance of unified decision-making can actually be problematic in its own right.

Katz: Absolutely. Let's hear about it, and let's have the Fed explain how it thinks about its pursuit of its inflation mandate. That's why I'm so concerned with the way that flexible average inflation targeting was rolled out without consulting the public more generally. We want monetary policy to be conducted with accountability rather than risk the Fed going off in its own directions and engaging in vacillations in policy. Now, predictably, we're getting calls for the Fed to change its inflation target from very, very prominent members of the economics profession. In fact, the Fed itself has embraced this scenario. We saw the most recent Summary of Economic Projections. The Fed is projecting that it's going to be running above its inflation target for the next two years while also expecting to cut rates.

Katz: And I think we should have a democratic debate about the direction of monetary policy rather than just leaving it to the Fed without any accountability to the democratic process. That's why I much prefer the system that the Bank of England has in place with respect to its own inflation targeting framework, where HMT specifies the inflation target, the Bank of England gets the authority to pursue that inflation target, and when inflation deviates from target, it has to explain itself. That, to me, is a much healthier framework than what we have now, which is very little accountability for the Fed as it explains its monetary policy decisions.

Beckworth: So, speaking of the Bank of England, Ben Bernanke recently concluded a review of its forecasts and the problems with it. But I found it interesting that they actually had a review process. The ECB recently reviewed its operating system, a corridor versus a floor system, and it's making some changes there. Of course, I'm a big fan of that, the direction they're going. RBA, the Reserve Bank of Australia, the Riksbank, they all came out after a review process and want to move their operating system in a direction that will shrink their balance sheet. Now, the key point from all of these examples is that there was a review, an acknowledgement that things aren't fine the way they are. My question to you is, do you believe that there will be similar considerations at the Federal Reserve by Congress to look at proposals like your own that would lead to these improvements? Do you see any scope for change at the Fed moving forward?

The Scope for Change at the Fed

Miran: I think [that] scope for change at the Fed is going to require Congress, ultimately, to think about a reform agenda, whether it's our proposal or another proposal, because the Fed has got itself in a situation where it very effectively controls the narrative and the information that comes out of the Fed and the review process and [the] personnel. And so, I don't see why they would take it on themselves to voluntarily give up power and authority and undergo a review process. It will require pressure to come from outside, and in some of those cases that you described, the pressure did come directly from parliaments, like, for example, in Australia. Was that the case in the UK as well that the pressure came from parliament, for the review of the BOE?

Katz: Yes and no. As far as I know, there wasn't pressure specifically to pursue the Bernanke reforms, but the House of Lords has had a very comprehensive review of inflation forecasting in recent years and made some other recommendations around the Bank of England's balance sheet policies and QE. And so, there's been a fair amount of interest in the UK on reform and the structure of the BOE generally.

Miran: So, the pressure has to come from outside to get a central bank to undertake that type of thing. And I think that the Fed is probably very comfortable that that pressure won't come. For our part, I think what we'd hope is that people start discussing the idea that there needs to be some reform of the Fed, because the system, as it is, basically takes too much political authority for what should be a nonpolitical institution. And so, what we want is for people to talk about ways in which we can make the system better. Not to burn the system down, but to make it better, to fix some of these problems, so that you can continue to have good monetary policy and good policy outcomes. 

Miran: And I think, in particular, there's a taboo among economists to criticizing the Fed, because economists tend to fall into this attitude that the second you start criticizing the Fed, and particularly the structure of the Fed in the way that we're doing, you're opening the door to the unwashed masses writing in a 10% inflation target, and you're opening a can of worms, and the slippery slope is so steep that you'll instantly fall down into hyperinflation. I think that's profoundly anti-democratic. I think that we need to think seriously about improving the system, to extend the longevity of the system for the long term, and to engineer a situation of good incentives for good monetary policy outcomes, and stop being so afraid of discussing how we can make it better.

Beckworth: Okay, with that, our time is up. Our guests today have been Dan Katz and Steve Miran. Dan and Steve, thank you so much for coming on the program.

Miran: Thank you, real pleasure.

Katz: Thanks for having us, David.

About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.