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By Patrick Horan [ [link removed] ]
This is the second of two articles on reforming the Federal Reserve; the first [ [link removed] ] concerns how to balance Fed independence and accountability in terms of monetary policy.
A few weeks ago, The Wall Street Journal reported [ [link removed] ] on a plan, written by advisers to former President Trump, that would give the president greater authority over the Federal Reserve, should Trump be reelected in November. Under this plan, the White House would review Fed banking regulations and emergency lending programs. Most controversially, the plan would give the president a say in monetary policy decisions and grant him the ability to remove the Fed chair.
Most economists agree that central bank independence is a critical feature of sound monetary policymaking, so the proposal has drawn criticism [ [link removed] ] from economists, members of Congress and Wall Street. Their concerns are justified: Greater politicization of the central bank typically leads to higher inflation because politicians tend to favor a “loose” monetary policy, which they believe will boost their popularity and reelection odds, even when such a policy would lead to excessive inflation.
Although we should be concerned about our elected politicians interfering with monetary policy, it’s important to remember that central bank independence is supposed to be a two-way street. Just as politicians are supposed to stay out of Fed affairs, the Fed should stay out of political issues, which are the domain of democratically elected policymakers. Unfortunately, in the past few years, the Fed has waded into a handful of issues beyond its traditional mission of monetary policy and bank regulation. The most important issue on which the Fed has overstepped is fiscal policy, which is Congress’ responsibility; but the Fed has also become involved with other issues including race, gender and inequality by dedicating professional research to these topics.
Monetary Policy vs. Fiscal Policy
The Fed’s main job is to use monetary policy to achieve its congressional mandate of price stability and maximum employment. Monetary policy involves adjusting the size of the “monetary base,” which includes currency and bank reserves held at the Fed. Monetary policy is supposed to be separate from fiscal policy—actions dealing with taxing, borrowing and spending. The Constitution gives Congress power over both monetary policy and fiscal policy. While Congress still directly sets fiscal policy, it has given the Fed, which it oversees, the authority to administer monetary policy.
Since the Fed adopted what economists call an “abundant reserve” framework in 2008, the distinction between monetary and fiscal policy has been blurred. Prior to 2008, the Fed had a “scarce reserve” system where it would buy and sell mainly short-term Treasury bonds (T-bills) using bank reserves. Under this system, the Fed could achieve its monetary policy objectives with a relatively small balance sheet [ [link removed] ]. For example, if the Fed wanted to pursue a looser, more expansionary monetary policy, it would buy T-bills from banks with newly created bank reserves. Those banks would then lend out those reserves to borrowers. Banks would not keep many reserves above the legal requirement because they would be missing out on interest-earning loans.
Under this system, both currency and bank reserves were considered to be “high-powered” money because banks would then lend out the money to the public, which would spend it on investment and consumption. “Higher-powered” money has the power to stimulate aggregate demand in the economy and raise total spending and inflation. If the Fed wanted to tighten monetary policy, this process would work in reverse.
In 2008, the Fed decided to switch to an abundant reserve system in which it paid interest on reserves held at the Fed at a higher rate than other short-term interest rates. Suddenly, banks had a strong incentive to accumulate large amounts of reserves and not lend them out, and bank reserves stopped being high-powered. Since then, the Fed has had the ability to expand its balance sheet without stimulating the broader economy and raising inflation.
Although the Fed made this transition because it wanted another monetary policy tool, the decision has caused the Fed to move more deeply into fiscal policy in at least two ways. First, it gave the Fed the ability to engage more in “credit policy,” in which it makes loans without increasing high-powered money. Credit policy redistributes credit across the economy to certain firms and is therefore a type of fiscal policy. To be sure, the Fed has provided credit throughout its history as a lender of last resort to the financial sector. However, before 2008, most Fed lending was relatively modest and confined to financial institutions. For example, the largest example of Fed lending to that point had been a loan of approximately $5 billion to Continental Illinois Bank in 1985.
By late 2008, however, the Fed had made much larger loans to troubled financial institutions and had begun a policy of “quantitative easing” (QE), in which it bought mortgage-backed loans to save the government-sponsored mortgage lenders Fannie Mae and Freddie Mac. These policies caused the Fed’s balance sheet to swell to $2 trillion. Under the old scarce reserve system, such policies would have increased the amount of high-powered money, which would have increased aggregate demand, fueled consumer spending and raised inflation. However, under the abundant reserve system, the Fed could expand its balance sheet and direct credit without this happening.
Over the next few years, the Fed pursued two more QE programs, causing its balance sheet to swell even further. Although the balance sheet shrunk somewhat in the late 2010s, the Fed’s response to the COVID-19 pandemic (more emergency lending plus the biggest round of QE, “QE4”) caused the balance sheet to peak at $9 trillion in 2022. During the COVID-19 crisis, the Fed also launched a panoply of lending programs to support not just banks, but also nonfinancial corporations, small and medium-sized businesses, and local and state governments.
It’s worth reiterating that neither emergency lending nor QE (the purchase of assets beyond traditional T-bills), by itself, is unconventional. However, the abundant reserve system enables the Fed to pursue both of these policies at much larger scales than otherwise would be the case. This has caused the Fed to have a much larger role in the allocation of credit across the economy—something that was formerly under Congress’ purview.
The second way in which the abundant reserve system causes the Fed to be involved in fiscal policy has to do with the profitability of the assets on the Fed’s balance sheet. When the Fed purchases bonds, it earns interest on those bonds and remits most of its profits to the Treasury Department. As I have previously written [ [link removed] ] in these pages, in the scarce reserve system, the Fed held a relatively small portfolio of T-bills, which pay little in interest because they mature very quickly. Therefore, the profits were modest and the revenue stream was predictable.
In an abundant reserve system, however, the Fed has a much larger portfolio and holds longer-term assets, which pay higher interest. If the interest the Fed pays on its bank reserves is lower than the interest it earns on its portfolio, a large balance sheet could be very profitable for the Fed and, by extension, the Treasury and taxpayers. Indeed, QE1, QE2 and QE3 all proved to be profitable. However, QE4 has been a very different story.
Unlike with the previous rounds of QE, inflation began to take off. To address inflation, the Fed dramatically raised the interest rate on reserves, so the interest it has paid to banks has greatly exceeded the interest it has been earning on its bond portfolio. The result has been massive losses, which some economists estimate will cost taxpayers about $1 trillion over the next decade.
The Fed’s foray into fiscal policy via its massive emergency lending and its balance sheet makes it vulnerable to politicization. One way for the Fed to solve this problem would be to return to a scarce reserve system where it does not operate with such a large balance sheet. While the Fed could do this [ [link removed] ], Fed officials have repeatedly [ [link removed] ] announced [ [link removed] ] that they prefer to stick with the abundant reserve system. If that continues to be the case, then Congress should become more involved in monitoring the Fed’s balance sheet.
Economist Andrew Levin and legal scholar Christina Skinner have outlined [ [link removed] ] how the Fed could be more transparent with Congress on balance sheet issues. For example, the Government Accountability Office could engage in comprehensive reviews of the Fed, something it currently does not do. The Fed could also conduct “stress tests” on itself to see how its balance sheet might be affected by hypothetical shocks and report those results to Congress. As Levin and Skinner point out, ironically, stress tests are something the Fed already requires large banks to do, so why shouldn’t the Fed have to do similar exercises?
Climate Change, Inequality and Other Issues
In recent years, some policymakers have called for expanding the Fed’s mandate to include addressing inequality and climate change. For example, in 2020, several congressional lawmakers sponsored [ [link removed] ] a bill to expand the Fed’s mandate to address income and wealth gaps across racial groups. That same year, Sarah Bloom Raskin, a former member of the Fed’s Board of Governors, criticized [ [link removed] ] the Fed for providing broad-based emergency loans because some of those loans went to oil and gas companies. In her view, those loans were inappropriate because such companies contribute to climate change.
Two years ago, my Mercatus colleague Scott Sumner observed [ [link removed] ] that inequality and climate change are long-run problems. However, in the long run, monetary policy is “neutral,” meaning it only affects variables denominated in current dollars, such as inflation or nominal GDP. It can’t affect real variables, such as employment or output, beyond the short run. Therefore, we should not expect monetary policy to be a useful tool in addressing issues such as income inequality and climate change.
Even in the short run, monetary policy would be a very poor tool to address inequality because the Fed has no reliable model for how to stabilize asset prices, which are a major determinant of wealth. Theoretically, the Fed could do more on these issues through its ability to regulate banks. Here, too, however, there would be problems: These are not issues the Fed is well-versed in and would distract the Fed from its core focuses of monetary policy and standard bank regulation.
Fortunately, these calls for broadening the Fed’s mission have stalled. The 2020 bill to expand the Fed’s mandate has not gone anywhere. Raskin took heat for her comments about the Fed lending to oil and gas companies, to the point that her second nomination to the Board of Governors was withdrawn. Earlier this year, Fed Chair Jerome Powell told Congress [ [link removed] ], “We are not climate change policymakers.” Powell’s words were encouraging, but it’s not clear this commitment would last under future Fed leaders. One way to ensure this commitment lasts would be for Congress to specifically limit the Fed’s ability to work outside its lane without clear congressional authorization.
Another way in which the Fed has drifted into politics is in the form of researching different economic issues. Research has been a critical function of the Federal Reserve regional banks for decades, as it helps inform Fed officials in formulating policy. Skinner and economist Carola Binder have documented a rise [ [link removed] ] in Fed research dedicated to such topics as inequality, climate change, race and gender in recent years. As of 2021, over 20% of Fed research was dedicated to what these authors call “activist” issues, as opposed to more traditional research topics such as macroeconomics and finance.
Defenders of Fed research in these areas may argue that the point of these studies is not to advance a specific political agenda, but to shed light on a variety of topics related to economic well-being. Moreover, as Skinner and Binder observe, having a large selection of research encourages intellectual debate, which is critical in a free society. Therefore, the authors do not recommend censoring such topics. Rather, they recommend that the Board of Governors establish research guidelines for the regional banks and require that the banks transparently report their research activities. The Board could also explain that research is intended to inform policy, but not to shape public opinion.
The Fed’s recent interactions with political issues, whether in its balance sheet decisions or in its research agendas, reveal a tension between independence and autonomy on one hand and accountability and transparency on the other. Since our economy is always evolving, Fed economists and officials need independence and flexibility to do their jobs well. However, the Fed is still a creature of Congress and must ultimately be held accountable to the public. The Fed and Congress should work together to create guardrails that balance these concerns. Clearly laying out the rules is the best way for Congress to keep the Fed accountable, while also insulating it from politicization.

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