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Today a vote is scheduled in the House of Representatives on passage of H.R. 459, Rep. Ron Paul’s “Audit the Fed” bill available here. All signs indicate that the bill will pass with bipartisan support, and the bill has more than 270 cosponsors. It calls for the Comptroller General to audit the Federal Reserve before the end of 2012, including auditing the Board of Governors and the unprecedented auditing of monetary policy deliberations and decisions. While this is likely to be one of the few bipartisan bills passed by the House this year, the additional scope of the audit created by this bill raises several questions about transparency of the Federal Reserve, Congressional oversight of Fed decisions, and exactly what the Fed is responsible for. Above all, the legislation makes apparent the overarching need for clarification of central bank mandates and just how the Fed is supposed to prioritize those objectives.
Since the financial crisis, the Federal Reserve has been subject to increased scrutiny over how the central bank pursues the primary objectives of monetary policy- low inflation and sustainable economic growth. The crisis of 2009 led to an expansion of central bank duties and powers world-wide and with it an increase in skepticism and distrust between the Federal Reserve and members of Congress calling for increased scrutiny and after-the-fact policing of both monetary policy and credit policy initiatives. However without first clarifying what duties the Fed is responsible for, Congress can’t reasonably hold the Fed accountable for failing at those duties. Put simply, the increase in the nature and scope of Fed activities combined with the lack of clarity surrounding Fed responsibilities and priorities has caused a typical Washington reaction: the call for audits, reports, and the expansion of regulation.
While few argue against the necessity of some oversight of the Federal Reserve, it’s important to stress the need to maintain the independence of the central bank in order to pursue effective monetary policies without undue influence of political whims. Independence is essential to ensure that the bank is able to react quickly to economic crises and market shocks without being subject to approval by Congress or the Treasury department. In order to ensure the Fed is able to react swiftly and decisively, independence is paramount. However there must also be a balance between autonomy and regulation in order to ensure that Fed policies have lasting legitimacy in the eyes of the public as being free of undue influence or manipulation and to ensure the Fed is ultimately accountable for its actions. Many argue that an overly regulated central bank subject to political calculations of elected officials will be unable to deliver sound monetary policies that accomplish the essential goals of low inflation and sustained growth because the necessary short-term pain to achieve those goals will be too politically unpopular. This is the simple and necessary tenant of having an independent Fed.
In the wake of the financial crisis Federal Reserve activities broadened to include not only traditional monetary policy but also broader supervision of banks and the stability of the financial system. This has created a conundrum for the central bank which is now engaged in expansive credit policy involving lending to institutions with varying degrees of risk financed by securities rather than the traditional “Treasuries only” approach. Whereas previously the Fed financed itself by purchasing only Treasuries and therefore avoiding carrying credit risk on its balance sheet, post credit-crisis the Fed has expanded credit initiatives carrying unsupervised, short-term, potentially risky non-Treasury securities increasing substantially the credit risk to the Fed and ultimately the tax payers. In the absence of decisive Congressional action to address our fiscal malaise, the Fed has undertaken expansive credit initiatives without clear objectives and in the absence of clear mandates. Without a clear and guiding fiscal plan restoring growth to the economy the Fed has tried to compensate for continued Congressional confusion and in a catch-22 position the Fed has strayed dangerously into the fiscal lane threatening the very independence that is essential to its operation.
This leads us to Rep. Paul’s bill which would expand GAO auditing authority to include the review of monetary policy decisions after the fact and essentially hold the Fed accountable for failed decisions. Before calling for additional auditing measures, one should understand what oversight the Fed is already subject to, what grey areas remain, and what is really needed to improve Congressional oversight in order to achieve effective results without subjecting federal monetary policy to increased politicization.
Currently the Fed is already subject to audit by the GAO through the Federal Banking Agency Audit Act, which authorized the audit the Board of Governors, the Reserve Banks and their branches. The bill did not include authority to audit monetary policy operations, foreign transactions, or Federal Open Market Committee (FOMC) operations. However, Congressional oversight over those areas is conducted through the requirement for reports and semi-annual monetary policy hearings. The Board of Governors publishes an annual report of activities and minutes of the FOMC meetings. In addition, a monetary policy reporting system was established in 1977 (as part of the Federal Reserve Reform Act of 1977), implementing a more detailed reporting and evaluation process to enable Congress to take a coordinated look at government economic policies. A series of regularly scheduled oversight hearings takes place during which the Federal Reserve reports to the banking committees on policy intentions. Finally, there are statutory requirements for semi-annual monetary policy reporting. In 2010, the Dodd-Frank reform bill sought to expand oversight and disclosure requirements for the Fed in order to increase transparency of Federal Reserve operations. Included in that was the requirement for GAO to audit all emergency lending by the Fed during the recent financial crisis and the authority to conduct future audits of emergency lending, discount window lending, and open market transactions.
While this seems to many like a lot of oversight, Rep. Paul is calling for even more auditing authority to “eliminate restrictions on GAO audits of the Federal Reserve and open Fed operations to enhanced scrutiny. We hear officials constantly lauding the benefits of transparency and especially bemoaning the opacity of the Fed, its monetary policy, and its funding facilities.” When questioned why additional audits were needed after those enacted in the Dodd-Frank legislation Paul replied, “The audit mandated in the Dodd-Frank Act focused solely on emergency credit programs, and only on procedural issues (such as the effectiveness of collateral policies, whether credit programs favored specific participants, or the use of third-party contractors) rather than focusing on the substantive details of the lending transactions. H.R. 459 does not limit the focus of the audit.”
Is more audit power, oversight and regulation necessary or proper? During his recent testimony in front of the House Financial Services Committee, Ben Bernanke argued unsurprisingly that it’s not (emphasis added):
I agree absolutely with Dr. Paul that the Federal Reserve needs to be transparent and it needs to be accountable.
I would argue that at this point, we are quite transparent and accountable on monetary policy. Besides our statement, besides our testimonies, we issue minutes after three weeks. We have quarterly projections, I give a press conference four times a year, there's quite a bit of information provided to help Congress evaluate monetary policy as well as the public.
Also very importantly, the Federal Reserve's balance sheet, its finances, its operations are thoroughly vetted. We produce an annual financial statement, which is audited by an independent external accounting firm. We provide quarterly updates and a weekly balance sheet. We have an independent I.G. We have additional scrutiny imposed by the Dodd-Frank Act.
And very importantly, and this is, I think, the crux of the matter, the general -- the Government Accountability Office, the GAO -- has extensive authority, broad authority to audit essentially all aspects of the Federal Reserve, and the Federal Reserve accepts that and is cooperative with the GAO's efforts.
There is, however, one important exception to what the GAO is allowed to audit under current law and that specifically is monetary policy deliberations and decisions. So what the Audit the Fed bill would do would be to eliminate the exemption for monetary policy deliberations and decisions from the GAO audit. So, in effect, what it would do is allow Congress, for example, to ask the GAO to audit a decision taken by the Fed about interest rates, for example.
Now that is very concerning because there's a lot of evidence that an independent central bank that makes decisions based strictly on economic considerations and not based on political pressure will deliver lower inflation and better economic results in the longer term.
So, again, I want to agree with the -- the basic premise that the Federal Reserve should be thoroughly transparent, thoroughly accountable. I will work with everyone here to make sure that that's the case. But I do feel it's a mistake to eliminate the exemption from monetary policy and deliberations, which would effectively, at least to some extent, create a political influence or a political dampening effect on the Federal Reserve's policy decisions.
If subjecting the Fed to audits on monetary policy and deliberations would create a damaging effect for successful monetary policy, then what should be done to ensure that the Fed is ultimately accountable for its policies and lending actions? The answer is for Congress to more precisely define the role of the Fed and its policy goals, prioritize those goals among each other where conflicts might arise, and clarify ambiguous Fed responsibilities to allow the Fed to carefully and clearly pursue the most important objectives.
According to Marvin Goodfriend, writing here for e21, effective Congressional oversight must begin with clarification of the Fed’s mandated responsibilities and priorities. Goodfriend writes, “Congress cannot reasonably and reliably hold the Fed accountable for exceeding its authority or for a dereliction of duty after the fact without clarifying Fed responsibilities before the fact.” The Fed has many mandates both explicitly imposed by law and implicitly imposed by public expectations, including maintaining price stability, promoting high employment, ensuring sustainable growth rates, and dealing with financial crises. In instances where Fed mandates are imposed by public assumption, there is a significant lack of clarity regarding both the boundaries of allowable Fed activity and what priorities should take precedence.
Recently this has been exemplified in calls for the Fed to address high structural unemployment figures while maintaining price stability. If structural unemployment (those unemployed due to a permanent mismatch of skills and demand in the labor market) is as large as many fear, the Fed will be put in the difficult position of addressing long-term unemployment while also balancing potential wage and price inflation caused by a lack of available skilled workers required for current job openings. Without clarity on which mandate the Fed should prioritize it’s probable that any action will be criticized as the “wrong” action after the fact should circumstances worsen.
Without clarity, the Fed has to presume what is expected, and markets are left to guess how the Fed will react to different scenarios, increasing uncertainty and delaying long-term recovery and growth.
In order to strengthen oversight, Goodfriend argues the following should occur:
- Congress should explicitly establish a long-term priority for price stability as a 2 percent inflation objective. It should then allow the Fed to conduct its daily monetary policy operations with that goal in mind and hold the Fed accountable if it fails to keep inflation within a prescribed range.
- The oversight process should force the Fed to justify any short-term policy actions to stabilize employment against the longer-term 2 percent inflation objective.
- The distinction between monetary policy and credit policy should be recognized for purposes of Congressional oversight. Because the Fed can implement monetary policy without credit risk by dealing only in US treasury securities, Congressional oversight should require the Fed to return to a Treasuries-only acquisition policy.
- Occasional lending to solvent and supervised entities in the short-term should deserve a degree of operational independence from Congress.
- Expansive Fed lending to less solvent entities at longer maturity and against weaker collateral (such as occurred during the recent crisis) incurs greater financial risks for taxpayers. Therefore, Congress should clarify the boundary of the Fed’s responsibilities for taking expansive credit actions and restrict its independence in doing so.
- Expansive Fed lending should be authorized before the fact by Congress only as a “bridge loan” accompanied by a “take out” arranged in advance by Congress. The process should include a clear public discussion of the fiscal risks.
Whatever steps are taken for continued oversight of the Fed, it seems clear that continued independence of central bank action in deliberating and deciding monetary policy remains paramount. The politicization of monetary policy through over regulation will weaken an already weak recovery effort and work directly against the goals of sustained growth, lower unemployment, and low inflation. Clearer directives on the mandates and priorities of Federal Reserve actions could add clarity and relieve the need for additional Congressional intervention and regulation allowing the Fed to maintain its independence in monetary policy.
Jennifer Pollom is the Chief of Staff at e21 and was the Appropriations and Budget Counsel for the Senate Republican Policy Committee.