By Steven K. Beckner
WASHINGTON (MNI) – Philadelphia Federal Reserve Bank President
Charles Plosser warns against monetary and fiscal policy entanglements
in an essay on the importance of central bank independence published in
the Bank’s newly released Annual Report.
And Plosser urges that the Fed return to an all-Treasury securities
portfolio and restrict its Section 13(3) emergency lending.
“The first and most important reason is to separate the authority
of those in government responsible for making the decisions to spend and
tax from those responsible for printing the money,” he writes. “This
lessens the temptation for the fiscal authority to use the printing
press to fund its public spending, which would substitute a hidden tax
of future inflation for taxes or spending cuts.”
Plosser, who will be a voting member of the Fed’s policymaking
Federal Open Market Committee next year, says “this can be especially
important when governments face huge deficits and may be tempted to use
the monetary printing press to improperly fund fiscal needs.”
He cautions, “the fiscal authorities should not think of the
central bank as a source of funds or a piggy bank they can use simply to
avoid the difficult choices of cutting spending or raising taxes….”
Plosser notes that central banks in countries ranging from Germany
to Zimbabwe have fallen victim to the temptation to become “agents for a
nation’s fiscal policy” in the past, with disastrous consequences.
Even in the U.S. there have been “periods where fiscal demands and
monetary policy became too intertwined,” he notes. “For example, in the
late 1960s and early 1970s, the Fed came under pressure from the
Treasury and the administration to support the funding of the Great
Society programs and the Vietnam War. As a result, the Fed became
reluctant to raise interest rates to restrain inflationary pressures.”
Plosser recalls that “this failure of the Fed to exert its
independence sowed the seeds of the Great Inflation in the 1970s. As
unemployment rose in response to the disruptions caused by the oil
shocks in that decade, the Fed remained reluctant to raise rates
sufficiently in the face of rising inflation.”
“Thus, the failure to keep monetary policy sufficiently independent
led the Fed to forsake its mandate for price stability, which resulted
in more than a decade of economic instability,” he adds.
Central bank independence from fiscal policy is more important
than ever now, Plosser maintains.
“More than ever before, we live today in a world of highly mobile
capital and financial markets that are constantly assessing the
credibility of governments and their central banks to maintain price and
economic stability,” he writes. “In such a world, the mere threat that
monetary policy might become politicized can damage the nation’s
credibility.”
“It can raise fears of inflation that send interest rates higher
and currencies falling,” he adds.
Plosser argues that central bank independence is also important
because “monetary policy affects the economy with sometimes long and
variable lags, but elected politicians, and even the public, often have
shorter time horizons.”
“Monetary policy actions taken today will not have their full
effect on the economy for at least several quarters and perhaps as long
as several years,” he explains. “That is why monetary policy choices
must focus on the intermediate to long term and anticipate what the
economy might look like over the next one to three years.”
What’s more, Plosser says “there can be a conflict between what
monetary policy may be able to achieve over the short term versus its
impact over the long term.”
While politicians want central banks to lower interest rates to
spur growth and jobs, “such effects are temporary at best and are highly
unpredictable,” he says, adding, “in the long term such a policy is
likely to result in higher rates of inflation and higher nominal
interest rates.”
While raising rates may hurt growth and jobs in the short-run, in
the longer run, growth will benefit from lower inflation.
“This pattern engenders an inflationary bias in policy if
policymakers become too short-term oriented,” Plosser writes.
“Delegating the decision-making to an independent central bank that can
focus on long-term policy goals is a way of limiting the temptation for
short-term gains at the expense of the future.”
Plosser emphasizes that independence “will be even more important
for the Fed going forward.”
“During the recent crisis, the Fed took extraordinary measures,” he
explains. “At some point, however, the Fed must unwind this support,
increase short-term interest rates, and drain some of the money it has
pumped into the economy during the recession.”
He declares that “the Fed must have the independence to take these
actions without short-term political interference if it is to achieve
Congress’s dual mandate.”
Alluding to legislative proposals that apparently will not find
their way into the financial regulatory reform bill, Plosser laments
that “instead of seeking to preserve or enhance the central bank’s
independence, however, some reform proposals would politicize the
governance of the 12 Reserve Banks by making the New York Fed president,
or even other Reserve Bank presidents, political appointees. Other
proposals would change the roles and responsibilities of the Fed.
Plosser warns that “such changes would weaken the regional and
decentralized structure of the Federal Reserve System and lead to a more
centralized and political institution, which would yield less effective
policymaking.”
“Were regional Reserve Bank presidents to become political
appointees, they would be more attuned to the political process in
Washington that selected them, rather than having a public interest in
the broad economic health of the nation and the Reserve Districts in
which they reside,” he says.
“Any shift in power in Washington and New York at the expense of
the other Reserve Banks would undermine the delicate balance of our
uniquely decentralized central bank and lead to a central bank that is
more interested in politics and Wall Street than in the economic health
of Main Street,” he adds.
Plosser argues for a different approach. “Rather than seek ways to
politicize the Fed, we should seek ways to ensure its independence from
short-term political pressures while reducing the temptation to use the
central bank as an inappropriate tool for conducting fiscal policy.”
He makes two suggestions, which he has made before in speeches:
— “First, the Federal Reserve should conduct monetary policy using
a portfolio that contains only Treasury securities, preferably
concentrated in bills and short-term coupon bonds.”
He says “this would contribute to preserving the Fed’s independence
by limiting activities that could be perceived as crossing the line from
monetary policy into the realm of fiscal policy.”
“The Federal Reserve’s purchases of mortgage-backed securities were
a direct intervention into housing finance and thus can be viewed as a
form of fiscal policy,” he goes on. “In order to return the composition
of the Fed’s portfolio to all-Treasuries, I would support the Fed’s
beginning to sell the agency mortgage-backed securities from its
portfolio as the economic recovery gains strength and monetary policy
begins to normalize.”
“Returning to an all-Treasuries portfolio would promote a clearer
distinction between monetary policy and fiscal policy and help uphold
the Fed’s independence,” he adds.
— Second, “eliminate or curtail the Fed’s 13(3) lending
authority,” which allows the Fed to lend to corporations, individuals,
and partnerships under “unusual and exigent circumstances.”
” believe the fiscal authorities should do emergency lending and
that the Fed be involved only upon the written request of the Treasury,”
Plosser writes. “Any non-Treasury securities or collateral acquired by
the Fed under such lending should be promptly swapped for Treasury
securities to make it explicitly clear that the responsibility for
fiscal policy lies with the Treasury and Congress, not with the Federal
Reserve.”
“To codify this arrangement, I have advocated for a new
Fed-Treasury Accord, similar to the 1951 accord that restored Fed
independence after World War II,” he continues. “This new accord would
eliminate the ability of the Fed to engage in bailouts of individual
firms or sectors and place such accountability where it rightly belongs
— with the fiscal authorities.”
** Market News International Washington Bureau: 202-371-2121 **
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