Instead of More Political Control, the Fed Needs More Rules and Transparency

By Patrick Horan

This is the first of two articles on reforming the Federal Reserve. This first essay in this series concerns monetary policy. A second piece will address ideas for limiting Fed “mission creep” into issues outside its mandate.

Last week, the Wall Street Journal reported that advisers to former President Trump are drafting a proposal to limit Federal Reserve independence should Trump win a second term. The plan includes subjecting Fed banking regulations to White House review and giving the Treasury Department more authority over Fed emergency lending programs like those implemented during the Great Recession of 2007-2008 and the 2020 COVID-related recession. Most controversially, the proposal would give the president a say in the making of monetary policy, the set of tools the Fed uses to adjust total liquidity in the economy to achieve its congressional mandate of price stability and full employment. The plan would allow Trump to dismiss the current Fed chair, Jerome Powell, and replace him with someone who would better reflect the president’s views on monetary policy decisions.

Many observers, ranging from Republican Sens. Kevin Cramer (N.D.) and Thom Tillis (N.C.) to economist Justin Wolfers, have criticized the plan, arguing that it would compromise the Fed’s ability to effectively conduct monetary policy. To be sure, there are good reasons to be worried about politicians’ threatening central bank independence, starting with the vast body of academic literature showing that greater independence is associated with lower inflation.

But if we want politicians to refrain from interfering with the Fed, then we should also demand limits to the Fed’s discretion and accountability for monetary policy missteps. Defenders of the Fed will counter, quite correctly, that in a changing world with changing risks, the Fed needs sufficient autonomy to adequately address unforeseen challenges. One way to resolve this tension would be to establish clearer “guardrails” for the Fed, which would grant it the flexibility it needs, especially in addressing crises, but still make it accountable to either Congress or the White House.

Balancing Independence and Accountability

Exercising a lot more political control over the Fed is very risky. Politicians are notoriously shortsighted in their goals and are usually not monetary policy experts. Traditionally, when the president and members of Congress have exerted a strong influence in central bank decision-making, they have tended to favor an especially expansionary policy to boost their favorability and reelection odds. Indeed, during his previous administration, Trump first criticized Chairman Powell for raising the Fed’s target interest rate too high, and then for not cutting that rate quickly enough. And Trump is by no means the first president to criticize the Fed, but he has been the most publicly critical since at least Harry Truman.

While the Fed should be guarded against political interference whether it comes from the president or Congress, policymakers should also reflect on the proper role of a central bank in a constitutional republic like ours. Just because the Fed is afforded autonomy to carry out the admittedly difficult task of getting monetary policy right does not mean there should be no oversight or checks on its discretion. Central bankers can make grave policy errors, which destabilize the whole economy. A case in point: Despite its best efforts and intentions, the Fed’s monetary policy decisions contributed substantially to the recent inflation surge, from which we are still recovering.  

Accelerating Too Fast

In March 2020, the Fed reduced its target interest rate and main monetary policy tool, the federal funds rate, to nearly 0% in response to the economic recession caused by the COVID-19 pandemic. Since it is difficult to implement conventional monetary policy when the federal funds rate is near zero, the Fed also engaged in “quantitative easing” (QE), buying trillions of dollars in longer-term bonds to boost liquidity (this program was called QE4 because the Fed had implemented three previous QE programs in the late 2000s and 2010s) and massively expanding its balance sheet from about $4.2 trillion to nearly $9 trillion. Finally, in an effort to inject confidence in the economy, the Fed provided aggressive “forward guidance,” communicating to the public that it would keep the federal funds rate at zero for years.

While these actions initially helped the U.S. economy recover from the 2020 recession, the Fed “kept its foot on the gas pedal” for too long, keeping the federal funds rate near zero and continuing QE through March 2022 even as inflation was creeping steadily above the Fed’s 2% target. As 2022 progressed, the Fed became increasingly concerned that inflation was more than just a transitory phenomenon and resorted to steep interest rate hikes to quell inflation. While inflation has fallen steeply since peaking in June 2022, it is still at 2.7% on a year-over-year basis, as measured by the Fed’s preferred Personal Consumption Expenditures Price Index measure. Moreover, the Fed has had to postpone previously planned interest rate cuts because inflation has not fallen as much as expected.

Meanwhile, the QE program has led to massive losses on the Fed’s balance sheet. When the Fed bought trillions in long-term bonds, the interest rates paid to it from those bonds were very low. However, when the Fed raises the federal funds rate, as it did in 2022 and 2023, it does so by paying higher interest rates on bank reserves held at the Fed. The interest rate the Fed is paying on bank reserves has greatly exceeded the interest rates paid to the Fed from the bonds it holds on its balance sheet.

The interest rate hikes also caused the value of the Fed’s portfolio to collapse because interest rates and bond prices move in opposite directions. To see why, suppose I buy a 10-year $1,000 bond with a 5% annual interest rate. Then, suppose the market interest on similar 10-year bonds rises to 6%. Investors would prefer newly issued bonds paying 6% interest rather than my bond only paying 5%. I would have to sell my bond at a discount if I no longer wanted it on my books. With the values of its assets dwarfed by its liabilities, the Fed has technically become insolvent. The economists William Nelson and Andrew Levin have estimated that QE4 might cost taxpayers as much as $1 trillion over the next decade.

Adding Some Guardrails

Defenders of the Fed argue that the COVID-19 pandemic was such an extraordinary event that we should cut the Fed some slack for not getting everything right over the past few years. Although this is a reasonable counterargument, it still stands that monetary policy errors harm the public. Therefore, monetary policy should generally be determined by a rule, constraining the Fed’s discretion. If extraordinary monetary policy is truly warranted, then Congress, which is more directly responsible to the public, should get involved.

One way to achieve this goal might be to require the Fed follow something known as the Taylor rule (a formula that determines the federal funds rate based on existing economic conditions) and to allow persistent deviations from this rule only with congressional approval. The original Taylor rule (named after economist John Taylor) called for adjusting the federal funds rate in response to changes in the inflation gap—that is, the gap between desired and actual inflation—and the output gap, which is the difference between actual economic output and “potential” output, or the maximum level of output economists think is possible on a sustained basis. However, there are many ways to modify this rule. For example, economists may want to write a Taylor rule that uses the unemployment rate as a measure rather than the output gap. Or they might use a forecast of inflation (say, what inflation is expected to be a year from now) rather than the existing inflation rate.

Once per year, the Fed could decide on which of these Taylor rules it thinks is most appropriate for achieving its mandate. It would make the parameters of that rule known to Congress and the public, and it would have to follow that rule plus or minus a percentage point. That plus or minus would give it some additional flexibility. For example, suppose the Taylor rule prescribes a 4% interest rate for the current quarter. The Fed could raise the federal funds rate as high as 5% or reduce it as low as 3% if it felt that 4% was not quite appropriate for achieving its mandate goals. If the Fed believes it needs to adjust the federal funds rate outside this band, say in the event of a financial crisis or an unexpected burst of inflation, it could do so, but only for a certain period, say three or six months. It would only be able to exceed this period with dongressional authorization. My Mercatus Center colleague and former Kansas City Fed president Thomas Hoenig supports a proposal very similar to this one.

Picking a Taylor rule would also not be a herculean task for the Fed. Many economists have done research on various rules to see which ones stand out as the best. For example, MIT economist and former central banker Athanasios Orphanides has recently argued for a rule where the Fed adjusts the federal funds rate in response to forecasted changes in total spending in the economy. In fact, the Fed, whether knowingly or unknowingly, has roughly followed this rule for the past three decades. The only instance when the Fed did not follow this rule was in 2021 and early 2022, when it fell well behind what the rule prescribed. If it had followed the rule, the Fed’s actions might have mitigated the inflation surge. If the reform described above were adopted, the Fed could start by implementing a rule like this.

Finally, what about QE? Like interest rate policy, QE policy is an area where Fed officials and staff will likely be more knowledge than Congress or the White House. Therefore, the Fed should be allowed to implement QE if the federal funds rate is expected to be at zero. However, the Fed should produce and regularly update a cost-benefit analysis of any such program for Congress. This change would force the Fed to be more transparent in weighing the pros and cons of QE and give Congress a clearer picture of what the Fed is up to. The Fed would also be forced to be more honest with itself in the event QE leads to huge losses, as was the case with QE4.

Central bank independence is an important feature of good monetary policy. However, independence should not be used to justify excess discretion and to avoid public scrutiny. If the Fed wishes to remain politically independent, it needs to be more transparent and rules-based.