U.S. GOVERNMENT PUBLISHING OFFICE

30–775 PDF WASHINGTON : 2018

EXAMINING FEDERAL RESERVE REFORM 

PROPOSALS 

HEARING 

BEFORE THE

SUBCOMMITTEE ON MONETARY 

POLICY AND TRADE 

OF THE

COMMITTEE ON FINANCIAL SERVICES 

U.S. HOUSE OF REPRESENTATIVES 

ONE HUNDRED FIFTEENTH CONGRESS 

FIRST SESSION 

NOVEMBER 7, 2017 

Printed for the use of the Committee on Financial Services 

Serial No. 115–56 

( 

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(II) 

HOUSE COMMITTEE ON FINANCIAL SERVICES 

JEB HENSARLING, Texas, Chairman 

PATRICK T. MCHENRY, North Carolina, 

Vice Chairman 

PETER T. KING, New York 

EDWARD R. ROYCE, California 

FRANK D. LUCAS, Oklahoma 

STEVAN PEARCE, New Mexico 

BILL POSEY, Florida 

BLAINE LUETKEMEYER, Missouri 

BILL HUIZENGA, Michigan 

SEAN P. DUFFY, Wisconsin 

STEVE STIVERS, Ohio 

RANDY HULTGREN, Illinois 

DENNIS A. ROSS, Florida 

ROBERT PITTENGER, North Carolina 

ANN WAGNER, Missouri 

ANDY BARR, Kentucky 

KEITH J. ROTHFUS, Pennsylvania 

LUKE MESSER, Indiana 

SCOTT TIPTON, Colorado 

ROGER WILLIAMS, Texas 

BRUCE POLIQUIN, Maine 

MIA LOVE, Utah 

FRENCH HILL, Arkansas 

TOM EMMER, Minnesota 

LEE M. ZELDIN, New York 

DAVID A. TROTT, Michigan 

BARRY LOUDERMILK, Georgia 

ALEXANDER X. MOONEY, West Virginia 

THOMAS MacARTHUR, New Jersey 

WARREN DAVIDSON, Ohio 

TED BUDD, North Carolina 

DAVID KUSTOFF, Tennessee 

CLAUDIA TENNEY, New York 

TREY HOLLINGSWORTH, Indiana 

MAXINE WATERS, California, Ranking 

Member 

CAROLYN B. MALONEY, New York 

NYDIA M. VELA ́ ZQUEZ, New York 

BRAD SHERMAN, California 

GREGORY W. MEEKS, New York 

MICHAEL E. CAPUANO, Massachusetts 

WM. LACY CLAY, Missouri 

STEPHEN F. LYNCH, Massachusetts 

DAVID SCOTT, Georgia 

AL GREEN, Texas 

EMANUEL CLEAVER, Missouri 

GWEN MOORE, Wisconsin 

KEITH ELLISON, Minnesota 

ED PERLMUTTER, Colorado 

JAMES A. HIMES, Connecticut 

BILL FOSTER, Illinois 

DANIEL T. KILDEE, Michigan 

JOHN K. DELANEY, Maryland 

KYRSTEN SINEMA, Arizona 

JOYCE BEATTY, Ohio 

DENNY HECK, Washington 

JUAN VARGAS, California 

JOSH GOTTHEIMER, New Jersey 

VICENTE GONZALEZ, Texas 

CHARLIE CRIST, Florida 

RUBEN KIHUEN, Nevada 

KIRSTEN SUTTON MORK, Staff Director 

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(III) 

SUBCOMMITTEE ON MONETARY POLICY AND TRADE

ANDY BARR, Kentucky, Chairman 

ROGER WILLIAMS, Texas, Vice Chairman 

FRANK D. LUCAS, Oklahoma 

BILL HUIZENGA, Michigan 

ROBERT PITTENGER, North Carolina 

MIA LOVE, Utah 

FRENCH HILL, Arkansas 

TOM EMMER, Minnesota 

ALEXANDER X. MOONEY, West Virginia 

WARREN DAVIDSON, Ohio 

CLAUDIA TENNEY, New York 

TREY HOLLINGSWORTH, Indiana 

GWEN MOORE, Wisconsin, Ranking Member 

GREGORY W. MEEKS, New York 

BILL FOSTER, Illinois 

BRAD SHERMAN, California 

AL GREEN, Texas 

DENNY HECK, Washington 

DANIEL T. KILDEE, Michigan 

JUAN VARGAS, California 

CHARLIE CRIST, Florida 

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(V) 

C O N T E N T S 

Page 

Hearing held on: 

November 7, 2017 ............................................................................................. 1 

Appendix: 

November 7, 2017 ............................................................................................. 41 

WITNESSES 

TUESDAY, NOVEMBER 7, 2017 

Bernstein, Jared, Senior Fellow, Center on Budget and Policy Priorities .......... 8 

Levin, Andrew T., Professor of Economics, Dartmouth College .......................... 7 

Levy, Mickey, Managing Director and Chief Economist, Berenberg Capital 

Markets ................................................................................................................. 10 

Plosser, Charles I., Visiting Fellow, Hoover Institution ....................................... 5 

APPENDIX 

Prepared statements: 

Bernstein, Jared ............................................................................................... 42 

Levin, Andrew T. .............................................................................................. 53 

Levy, Mickey ..................................................................................................... 112 

Plosser, Charles I. ............................................................................................ 120 

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(1) 

EXAMINING FEDERAL RESERVE REFORM 

PROPOSALS 

Tuesday, November 7, 2017 

U.S. HOUSE OF REPRESENTATIVES, SUBCOMMITTEE ON MONETARY POLICY AND TRADE, COMMITTEE ON FINANCIAL SERVICES, Washington, D.C. 

The subcommittee met, pursuant to notice, at 2:19 p.m., in room 

2128, Rayburn House Office Building, Hon. Andy Barr [chairman 

of the subcommittee] presiding. 

Present: Representatives Barr, Williams, Huizenga, Pittenger, 

Love, Hill, Emmer, Mooney, Davidson, Tenney, Hollingsworth, 

Moore, Foster, Sherman, Green, Kildee, Vargas, and Crist. 

Chairman BARR. The chair is authorized to declare a recess of 

the committee at any time, and all members will have 5 legislative 

days within which to submit extraneous materials to the Chair for 

inclusion in the record. 

This hearing is entitled ‘‘Examining Federal Reserve Reform Proposals.’’ I now recognize myself for 5 minutes to give an opening 

statement. 

Some see the last decade of monetary policy as a failure, while 

others see it as a success. Wherever we stand on this debate, I 

hope we can all agree that stronger economic growth over recent 

quarters is promising and American economic opportunities can expand even faster with reforms that build on the best ideas from 

both sides of our aisle. 

The legislation we will consider today does just that. Monetary 

policy can appear complicated, but whether you work in the Fed’s 

Eccles Building or in any of our districts, monetary policy supports 

a stronger economy when it is communicated simply and clearly. 

Recent Fed research finds that uncertainty about monetary policy 

slows our economy and reduces credit availability. In other words, 

simple and clear policy communications improve American economic opportunities. 

Both Democratic and Republican witnesses have testified before 

us on the importance of a simple and clear communication of monetary policy. For example, during our last Humphrey-Hawkins hearing, Federal Reserve Board Chair Yellen expressed interest in 

working with our committee to codify a simple and effective strategy for a more transparent monetary policy. 

In addition, former Vice Chair of the Federal Reserve Board Dr. 

Donald Kohn offered the following advice in a recent Brookings Institution report. The Federal Reserve should use the semi-annual 

monetary policy report to better explain and focus on its broad 

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2 

strategy. For some time, the Fed’s Open Market Committee has 

been shown the results of a number of policy rules, and this material has been accompanied by explanations of why the current and 

expected settings of monetary policy might deviate from the rules. 

The Monetary Policy Transparency and Accountability Act that 

we will consider today provides for exactly this type of framework. 

Indeed, this bill reflects the very generous advice of both Chair 

Yellen and Dr. Kohn. Our draft legislation also addresses what 

Members of Congress and experts from both sides of the aisle see 

as an opportunity to better manage our fiscal house and increase 

our financial resiliency by protecting households from bailouts and 

holding Congress to account for tough decisions that can easily be 

punted to the Fed. Our congressional Accountability for Emergency 

Lending Act takes an important step in this direction by embracing 

this bipartisan Warren-Vitter framework for congressional approval 

of emergency lending. 

At the same time, our Independence from Credit Policy Act maintains the Fed’s role as an originator of emergency loans while insulting our monetary authority from compromising political pressures to overreach into credit policy. Authoritative economists of 

different stripes share a common concern about these pressures. 

Testifying as a witness for my Democratic friends, MIT Professor 

Simon Johnson emphasized this bipartisan agreement. 

I think we are all agreeing that this fiscal policy infrastructure 

is the responsibility of the fiscal authority, which is that of the 

Congress and the United States acting through the Executive 

Branch. It is not the responsibility and should not become the responsibility of the Federal Reserve. 

Recently, Brandeis Professor Stephen Cecchetti shared the same 

concern as a minority witness for our Joint FI-MPT Subcommittee 

hearing. And even the New York Times’ Paul Krugman joined this 

chorus, highlighting how the Fed’s unconventional balance sheet 

blurs the lines between monetary and fiscal policies. 

Acknowledging such concerns during our last Humphrey-Hawkins hearing, Federal Reserve Board Chair Janet Yellen committed 

the FOMC (Federal Open Market Committee) to re-establishing a 

bright line between monetary and credit policy. She said the FOMC 

has clearly indicated that it intends to return over time to a primarily Treasury-only portfolio. And that is in order not to influence 

the allocation of credit in the economy. 

Coupled with our congressional Accountability for Emergency 

Lending Act, the Independence from Credit Policy Act does precisely what Chair Yellen has advocated—a return to a primarily 

Treasury-only portfolio while maintaining the Fed’s role as an 

originator of emergency loans. 

Greater transparency, independence, and accountability for monetary policy coupled with greater fiscal accountability for Congress, 

that is a solid bipartisan recipe for what we all want, and that is 

greater economic opportunity for all Americans. I look forward to 

our witnesses’ testimony and working with my friends on both 

sides of the aisle to realize the considerable benefits that this legislative package will deliver to each of our diverse constituents. 

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The Chair now recognizes the ranking member of the subcommittee, the gentlelady from Wisconsin, Gwen Moore, for 3 minutes for an opening statement. 

Ms. MOORE. Thank you so much, Mr. Chairman. And I want to 

thank our witnesses for coming in today. I look forward to your testimony. 

As for the bills we are considering, on one hand, I think that 

they are better than the other Audit the Fed bills we have seen, 

but overall they seem like problems foisted into a functioning system. I am glad that the majority has abandoned the so-called Taylor rule, but a watered-down Taylor rule is probably as unworkable 

if the Taylor rule is flawed. 

The 13(3) authority, I have my own questions about it, but I have 

spent some time with the Fed understanding the importance of 

13(3). Dodd-Frank made the right amount of reforms to the Fed in 

this regard, and I sure hope that the new Fed chair would really 

sit down with Chair Yellen and really let her explain the benefits 

that 13(3) has had. 

At this point, I think the one thing that frightens me the most— 

and I would appreciate more clarity from this panel on—is the restriction of what the Fed holds, this Treasury-only schemata. It 

seems to me that this would be very problematic—this would have 

been problematic had it been in place during our crisis. So like I 

said, I don’t see the problem that these bills are designed to solve, 

but I can see plenty of problems this legislation might cause. 

I would like to yield the rest of my time to Mr. Sherman. 

Mr. SHERMAN. The Fed should be restructured in part because 

it is so highly undemocratic. It is the only governmental institution 

where at least some of the leaders are selected by the notion one 

bank, one vote. All Fed Governors at all levels should be Presidential appointees. 

Second, it is undemocratic because the California bank does not 

have a permanent seat on the Fed committee, whereas the New 

York bank does, whereas far more people live in the California region. The allocation of seats should reflect population, not political 

power. 

If there has been a failure of Fed policy, it is because they were 

too timid with quantitative easing. And now they are too hawkish 

when it comes to raising the interest rate. Our inflation rate is not 

only below their target, it is below the target they should have, 

which would be closer to 2.5 percent. 

We continue to have low wages. What Americans demand is the 

kind of labor shortage that will cause much faster growing wages. 

That cannot be achieved with the Fed’s current timid policy of caving in to those who just, for historical reasons, believe we should 

have higher interest rates and abolish quantitative easing. 

Finally, it is only because Fed policy is the domain of people who 

live in the Fed world that we ignore the $75 billion to $100 billion 

the Fed has been able to transfer to the U.S. Treasury. In my district, that is real money, and yet it doesn’t get the—we pay far 

more attention on the cost of building one bridge in Alaska than 

we have in $75 billion to $100 billion transferred to the U.S. Treasury for several years in a row because nobody pays attention to the 

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Fed except the Fed community, and the Fed community is embarrassed by its profit. 

I yield back. 

Chairman BARR. The gentlelady’s time has expired. Would the 

gentlelady yield back? 

Ms. MOORE. I yield back. 

Chairman BARR. Gentlelady yields back. At this time, we would 

like to welcome the testimony of our witnesses. First, Dr. Mickey 

Levy, the Chief Economist for the Americas and Asia at Berenberg 

Capital Markets. He conducts research on a variety of U.S. and 

global economic and macroeconomic topics and is an adviser to several Federal Reserve banks, including the Federal Reserve Bank of 

New York. Prior to his current position, Dr. Levy was Chief Economist at Bank of America and Blenheim Capital Management. He 

also has been analyst at both the Congressional Budget Office and 

the American Enterprise Institute. Since 1983, he has served as a 

member of the Shadow Open Market Committee. 

Dr. Andrew Levin, a Professor of economics at Dartmouth College. He was an economist at the Federal Reserve Board for 2 decades, including 2 years as a special adviser to Chairman Bernanke 

and then Vice Chair Yellen on monetary policy strategy and communications. He subsequently served as an adviser at the International Monetary Fund. Professor Levin is currently an external 

adviser to the Bank of Korea and a regular scholar at the Bank of 

Canada. He has also served as a consultant to the European Central Bank and as a visiting scholar at the Bank of Japan and the 

Dutch National Bank. And he has provided technical assistance to 

the National Banks of Albania, Argentina, Ghana, Macedonia, and 

Ukraine. He received his PhD in economics from Stanford University in 1989. 

Jared Bernstein is the Senior Fellow at the Center on Budget 

and Policy Priorities. From 2009 to 2011, Bernstein was the Chief 

Economist and Economic Adviser to Vice President Joe Biden; Executive Director of the White House Task Force on the Middle 

Class; and a member of President Obama’s economic team. Bernstein’s areas of expertise include Federal and State economic and 

fiscal policies, income inequality and mobility, trends in employment and earnings, international comparisons, and the analysis of 

financial and housing markets. 

Prior to joining the Obama Administration, Bernstein was a Senior Economist and the Director of the Living Standards Program at 

the Economic Policy Institute in Washington, D.C. Between 1995 

and 1996, he held the post of Deputy Chief Economist at the U.S. 

Department of Labor. Bernstein holds a PhD in social welfare from 

Columbia University. 

Finally, Dr. Charles Plosser is a Visiting Fellow at the Hoover 

Institution at Stanford University. Plosser served as the President 

and CEO of the Federal Reserve Bank of Philadelphia from 2006 

until his retirement in 2015. In his position, he served as a member of the Federal Open Market Committee. Prior to joining the 

Federal Reserve, Plosser was the John M. Olin Distinguished Professor of Economics and Public Policy and Director of the Bradley 

Policy Research Center at the University of Rochester’s William E. 

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5 

Simon Graduate School of Business Administration, where he 

served as Dean from 1999 to 2003. 

In 2004, he was a visiting scholar at the Bank of England. Since 

January 2016, Plosser has served as a Public Governor for FINRA, 

where he serves on the Investment Committee and the Financial 

Operations and Technology Committee. Plosser earned his PhD 

and MBA degrees from the University of Chicago. 

Each of you will be recognized for 5 minutes to give an oral presentation of your testimony. Without objection, each of your written 

statements will be made part of the record. Dr. Plosser, we will 

start with you. You are now recognized for 5 minutes. And if you 

could just push the button to turn on your microphone. 

STATEMENT OF CHARLES PLOSSER 

Dr. PLOSSER. I am technologically challenged at times. 

Chairman BARR. Thank you, sir. 

Dr. PLOSSER. Chair Barr, members of the committee, thank you 

very much for the opportunity to share some thoughts with you 

today on the Federal Reserve. I have been talking about the Federal Reserve for the last 20 years at various times, and so I have 

given a lot of thought to many of its issues. 

It is simplified but helpful to think of Fed actions in terms of its 

balance sheet, liabilities, predominantly currency, and the reserves 

of the balance sheet. Increasing the liabilities is typically associated with monetary policy. However, the Fed can also manage the 

asset side of its balance sheet. Changes in composition of those assets are typically referenced to as credit policy. 

Historically, the Fed has conducted monetary policy through the 

purchase or sale of Treasury securities. Indeed, the vast bulk of the 

Federal Reserve assets have been U.S. Treasuries since the modern 

Fed began in the 1950’s. Credit policy simply did not play a role. 

Moreover, for most of the post-World War II era, the Fed’s portfolio of Treasuries was purposefully designed to be neutral vis-a-vis 

the private sector. It only held Treasuries, and the distribution 

among bills, notes, and bonds was managed to roughly match the 

distribution of the Treasury’s issuances. In other words, it was felt 

that the Fed’s portfolio should not try to alter the relative prices 

determined in the marketplace. 

Now, during the financial crisis and subsequent recession, the 

Fed altered both the size and composition of its balance sheet. In 

early 2008, the Fed sold Treasuries to fund the purchase of approximately $30 billion of mostly private-sector high-risk assets to 

support the acquisition of Bear Stearns by JPMorgan. Credit was 

also extended through various other lending programs that targeted specific industries, asset classes, and creditors. 

Now, whether you can consider these as justified because of the 

credit or not, they were, in effect, debt-financed fiscal policy without explicit authorization of Congress. Now, given the distributional effects of such interventions, it is not surprising they became 

somewhat controversial. 

The major form of—another major form of credit policy was the 

result of quantitative easing. QE was unconventional, but it was 

also unprecedented in that a significant portion of the assets purchased were in the form of mortgage-backed securities, not U.S. 

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Treasuries. This action was explicitly intended to provide credit 

support for the housing sector. 

So why should the Fed have the authority to allocate credit within the economy in support of one industry, one company, or one individual? What are the risks and dangers of such a framework? 

The major risk is that it invites political interference and undermines the integrity of fiscal policy. History suggests that central 

banks that remain independent of the political environment and 

the fiscal authorities do better at controlling both inflation and promoting economic stability. Do we really want the Fed being lobbied 

by Congress or the public to manage the assets on its balance sheet 

to promote various political or fiscal agendas? 

The current trends I believe are not encouraging. For example, 

some Members of Congress approached the Fed to lend money to 

the automobile companies in 2008. In 2010, Congress required the 

Fed to fund a Federal agency over which it had no authority. And 

in 2015, Congress funded part of a transportation bill off the Fed’s 

balance sheet. 

I believe these actions are bad policy. They undermine the independence of our central bank monetary policymaking by confusing 

the roles and responsibilities of monetary and fiscal policy. Fed 

independence is fragile, and it is eroding. The Fed itself is contributing to this erosion of independence by engaging in off-budget fiscal policy through credit allocations. 

A policy that restricts the Fed to own only Treasuries would go 

a long way toward limiting the Fed’s ability to engage in credit allocation and limit the potential for abuse or political abuse in particular of its balance sheet. It would also help maintain a clear distinction between the role of the Fed and the role of the fiscal authorities, and thus help protect it from political interference. 

Some say an all-Treasury portfolio was dangerous and would 

limit the Fed’s ability to respond in a fiscal crisis. But since 2009, 

I have been arguing that there is a better way. And it is to recognize and clarify who has the decision rights when it comes to fiscal 

decisions and who should be held accountable. The idea is to make 

clear that such emergencies is—it is the fiscal authorities that have 

the power and the authority to conduct fiscal actions, who should 

own both the decision rights and the accountability. 

The role of the Fed should be limited to helping the government 

execute those policies, but the Treasury would then be responsible 

for obtaining approval of Congress for the interventions and then 

required to swap Treasuries for non-Treasury securities acquired 

by the Fed, thus restoring the all-Treasury character of the Fed’s 

balance sheet. 

This Fed Treasury accord would enable emergencies to be addressed in a timely manner while protecting the integrity, accountability of fiscal policy decisionmaking. 

[The prepared statement of Dr. Plosser can be found on page 120 

of the Appendix.] 

Chairman BARR. The gentleman’s time is expired. And we look 

forward to continuing this discussion in the Q&A. So we will now 

have to move on to Dr. Levin. You are recognized for 5 minutes for 

your opening statement. 

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STATEMENT OF ANDREW LEVIN 

Dr. LEVIN. Chairman Barr, Ranking Member Moore, and members of the Subcommittee on Monetary Policy and Trade, thank you 

for inviting me to testify at this hearing. 

The Federal Reserve is America’s central bank. Its monetary policy decisions affect every American. Given the Fed’s crucial role, it 

is important to ask, to whom is the Federal Reserve accountable? 

Who is the Fed’s boss? 

Of course, the answer is Congress. The Fed reports directly to 

Congress, not to the President or anyone else. Now, I have intentionally used the term ‘‘boss’’ because we can draw on basic management principles to shed light on the issues being considered 

here today. 

Turning to exhibit one, here are three principles that are followed by every well-run business or nonprofit organization. One, 

the boss must stay well informed about the employee strategy. 

Those consultations take place in annual reviews and occasional 

status updates, which are essential for maintaining accountability 

and avoiding micromanagement. After all, an employee can’t be 

productive if the boss is constantly second-guessing their decisions. 

And that is the basic rationale for preserving the Fed’s operational 

independence, but requiring the Fed to explain its policy strategy 

in terms of simple benchmarks, which I will return to in a moment. 

Two, extraordinary budget items require prompt approval. An 

employee should have authority to incur routine expenses, but the 

boss has to approve extraordinary items. And that principle is the 

essential rationale for preserving the Fed’s operational independence, again, but establishing procedures to facilitate prompt congressional approval for its emergency lending facilities. 

Three, extraneous tasks should be re-assigned elsewhere. Effective delegation requires a clear delineation of responsibilities. If a 

work assignment evolves into a task that doesn’t fit within the employee’s job description, then the boss should re-assign that task to 

someone else. 

Following the same logic, private assets shouldn’t stay indefinitely on the Fed’s balance sheet. Those assets should be swapped 

for U.S. Treasury securities, again, preserving the Fed’s operational independence and its designated scope of responsibility. 

Now I would like to focus on the rationale for establishing simple 

policy benchmarks. Turning to exhibit two, you can see that as of 

last June, investors saw roughly 50/50 odds, just like a coin flip, 

that the Fed would hike interest rates in December. Those odds 

edged down during the summer, but then skyrocketed into early 

autumn, not because of some sterling new economic data, but simply because Fed officials started signaling a rate hike through their 

speeches and interviews. 

In fact, as you see in the exhibit, investors now see the rate hike 

in December as a practical certainty, even though the FOMC won’t 

be meeting until mid-December, almost 6 weeks from now. Evidently, the strategy underlying the Fed’s decisions is not very well 

understood, even by investors who sift through every tidbit of Fed 

communications, and much less so by members of the general public. 

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By contrast, simple benchmarks can provide a transparent 

means for the Fed to communicate its strategy. It is really important to note here such benchmarks are not intrinsically hawkish or 

dovish. For example, Janet Yellen, when she was Vice Chair in 

2012, referred to one such benchmark as the balanced approach 

rule because of its effectiveness in fostering the Fed’s dual mandate 

of maximum employment and price stability. 

Turning now to exhibit three, you can see here that a balanced 

approach benchmark provides a remarkably good approximation to 

the Fed’s actual policy path over the last few years. In fact, this 

benchmark is essentially the same as one I presented at a conference on full employment that my colleague, Jared Bernstein, organized back in 2015. This exhibit shows, it confirms that simple 

benchmarks can be helpful in clarifying the Fed’s monetary policy 

strategy. That will contribute to its overall transparency and accountability to the Congress, its boss, and to its effectiveness in 

serving the American public. 

Thank you for your consideration. I will be glad to answer any 

questions. 

[The prepared statement of Dr. Levin can be found on page 53 

of the Appendix.] 

Chairman BARR. Thank you, Dr. Levin. And, Dr. Bernstein, you 

are now recognized for 5 minutes. 

STATEMENT OF JARED BERNSTEIN 

Dr. BERNSTEIN. Well, thank you very much. Great to be here. 

And my testimony conveys a simple message. The independence of 

the central bank is an essential ingredient to its functioning. Of 

course, that independence exists within the legal context set forth 

by Congress and it is essential for this committee to continuously 

revisit this context. 

But maintaining the central bank’s independence must always be 

an elevated consideration. In this context, some of the ideas and 

the proposals under discussions are worthy of consideration, but 

some are too restrictive. They threaten the Fed’s independence and 

add unnecessary and potentially damaging process requirements 

that could do more harm than good to the U.S. and even the global 

economy. 

Before commenting on the proposals, I would like to suggest that 

in an all-too-other dysfunctional and highly partisan environment, 

the Federal Reserve is one institution that has been highly effective in carrying out its mission. Though the Fed failed to identify 

the housing bubble, it quickly moved into emergency mode when 

the bubble burst and the downturn ensued. 

The bank deployed its significant weaponry against the downturn, including its first line of defense, reductions of the policy rate 

and emergency lending, and later when the policy rate got stuck 

at its lower bound of zero, the Fed turned to alternative forms of 

monetary stimulus. 

While some of these actions are behind the motivations for today’s hearing, my assessment is that they were effective in offsetting the historically large demand contraction that followed the crisis. I cite research that tries to isolate the impact of quantitative 

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easing, including bond purchases that would not be permissible, 

agency MBS (mortgage-backed security), under one of the proposals 

considered today. These actions were effective in thawing credit 

markets in hard-hit sectors of the market, noticeably housing finance. 

Post-recession, the Fed continued to promote the recovery and 

the unemployment rate recently fell to what is now the lowest jobless rate in 17 years. In other words, if I were looking around 

Washington for an institution that fits the adage ‘‘if it ain’t broke, 

don’t fix it,’’ my first thought would be the Federal Reserve. 

Among the three proposals under review today, I find the proposal to limit the Fed’s independence regarding its emergency lender of last resort function potentially most problematic. Though I 

recognize the motivation for the proposal, I see two major drawbacks. 

First, since the crisis, Congress legislated the Dodd-Frank financial reforms, key sections of which were designed specifically to reduce the need for Fed intervention in this space, including a vice 

chair position for the Fed, for financial supervision, numerous restrictions to 13(3) lending authorization, and liquidation authority. 

Dodd-Frank, along with recent international accords under Basel 

III, also increased the first line of defense against illiquidity and 

solvency crises, capital requirements that disallow excessive leverage. I see no reason to add new complexities into this system until 

we give the Dodd-Frank measures a chance. 

Second, and this is a profound concern with this proposal, it 

takes the authority for emergency lending outside of the Fed and 

requires both chambers of Congress to provide a timely 30-day approval of the Fed’s emergency loans. I believe this adds unnecessary risk to credit markets and the broader economy. It is an imprudent departure from the lending authority established in 13(3) 

of the Fed’s charter, one that undermines both the independence of 

the institution and its role of, quote, lender of last resort. With this 

change, the 535 Members of Congress all become lenders of last resort, a possibility I strongly urge this committee to avoid. 

If Congress fails to approve an emergency lending program within 30 days, the borrower, who by definition is facing a balance 

sheet crisis, must pay the loan back to the Fed. Moreover, Members of Congress and their staffs must quickly engage in highly 

technical analysis of whether lending institutions are illiquid or insolvent, the quality of their collateral. Such analysis is standard 

practice at the Fed, but by insisting Congress engage in it as well, 

the proposal introduces the possibility of politicizing the analysis— 

and if Congress fails to act in a timely manner—triggering significant market disruptions. 

I do think the bar should be high for approval of emergency lending, but my bottom line is that clearing that bar should be the purview of the Fed, not Congress. Thus, should the committee consider 

raising the internal bar within the Fed, inside the Fed, while this 

should be done carefully and with great attention to potential unintended consequences, it is consistent with prudent congressional 

regulation. 

Conversely, raising the external bar by requiring congressional 

approval goes way beyond this benchmark. The best way to avoid 

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emergency lending by the Fed is to avoid credit bubbles, systematically underpriced risk, and the crises that followed these financial 

pathologies. And the way to achieve that is through market oversight and regulation. 

I would also caution the committee against further restrictions 

on the Fed as to the type of debt they can purchase in their open 

market regulations. The Banks of England, Japan, Canada, and 

Europe all have few restrictions on the type of assets they can purchase, and this creates a flexibility for their central banks to bring 

the water to the specific sources of the fire. 

I thank you, and I look forward to your questions. 

[The prepared statement of Dr. Bernstein can be found on page 

42 of the Appendix.] 

Chairman BARR. Thank you, Dr. Bernstein. And, Dr. Levy, you 

are now recognized for 5 minutes for an opening statement. 

STATEMENT OF MICKEY LEVY 

Dr. LEVY. Chairman Barr, Ranking Member Moore, and members of the committee, I sincerely appreciate this opportunity. 

The ultimate objective is healthy, sustained economic growth and 

rising standards of living. The challenge is identifying the proper 

policies and the proper mix of policies—fiscal and tax, regulatory 

and monetary—to achieve desired outcomes. The Fed’s emergency 

measures during the 2008–2009 crisis certainly helped stabilize financial markets and avert an even deeper recession. But we have 

to distinguish between the conduct of policy during a crisis and 

during normal times. 

The efficacy of the Fed’s sustained artificially low interest rates 

and massive asset purchases once the recovery took hold are questionable and have been the source of undesired distortions and pose 

very large risks. The Fed’s QE3 asset purchases policy to reinvest 

all the maturing assets, artificially low interest rates, all of these 

stimulated financial markets. But they failed to stimulate faster 

growth. Nominal GDP growth has actually decelerated. 

The economy would have grown along its modest pace and job 

gains would have occurred even if the Fed had not engaged in QE3 

and even if it had normalized rates quicker. History shows conclusively that once an economic recovery takes hold, raising rates back 

to neutral does not harm the economy. 

But the Fed’s extension of monetary policy through uneven discretionary approaches has given a false sense or a false impression 

that the mandate of the Fed is to manage the real economy and 

fine-tune it, and that more and more monetary stimulus was needed to prop up the economy. In reality, the frustrating underperformance of the economy reflected the growing web of regulatory 

policies, government-mandated expenses, and tax burdens. 

The Fed’s extended easy policies has created many distortions 

and burdens. Let me mention a few. Tens of millions of primarily 

older people face low yields on their savings. Tens of millions of 

renters face higher rental costs as real estate prices have moved 

up, stimulated by the Fed. Moreover, the Fed’s $4.5 trillion portfolio involves enormous risks. The CBO estimates that a 1 percentnshattuck on FSR297 with DISTILLER

11 

age point increase in interest rates would increase budget deficits 

by $1.6 trillion over 10 years. Take this risk seriously. 

My recommendations are, the Fed must continue to normalize interest rates as it has been. With regard to inflation, the factors 

that have brought down inflation recently below the Fed’s 2 percent target are good for the economy and increased purchasing 

power. The Fed should not express so much public angst about a 

non-problem of low inflation. 

In fact, economic growth, business investment, and real wages 

are picking up momentum and confidence is elevated despite the 

Fed hiking rates. The reason for this is largely the government’s 

recent changes to ease the burdensome regulations and tax reform 

prospects. 

Second, the Fed and Congress are really too complacent about 

the Fed’s massive balance sheet, particularly amid improving 

economies. And I urge the Fed to gradually eliminate its entire 

mortgage-backed securities holdings. With the mortgage market 

healthy, and housing doing quite well, why is the Fed holding any 

MBS? Why is it allocating credit to a sector that doesn’t need it? 

The Fed should aim to reduce its balance sheet much more than 

it is currently aiming for. Some Fed members are talking about 

lowering it from its current level to about $3 trillion, which would 

still leave $1 trillion in excess reserves in the banking system. We 

need to assess the costs as well as the potential benefits of that. 

What might be the costs? Its involvement in fiscal policy, paying 

interest on excess reserves, the Fed’s expanded footprint in financial markets. 

Third, the Fed and Congress should adopt a rule to establish and 

prevent the Fed from ever purchasing equities under any circumstances. 

Finally, and most importantly for the future, the Fed really 

needs to reset monetary policy. It should have a flexible rulesbased approach. And by flexible, what I mean is, follow a rule as 

a guideline that will improve transparency and your committee’s 

ability to supervise the Congress while at the same time giving the 

Fed substantial or any types of discretion it needs during emergency situations. 

Thank you. 

[The prepared statement of Dr. Levy can be found on page 112 

of the Appendix.] 

Chairman BARR. Thank you all for your testimony. And the 

Chair now recognized himself for questions for 5 minutes. 

So last year, a research team from the University of Chicago, 

Northwestern, and Stanford published an article in the highly regarded Quarterly Journal of Economics. And that article found that 

uncertainty about economic policy in general reduces American investment, output, and employment. 

And just last month, a team at the Federal Reserve, researchers 

at the Fed found the same problem with monetary policy. According to their study, quote, ‘‘uncertainty about monetary policy increases credit spreads and reduces output.’’ 

Dr. Plosser, you have served on the Fed’s Monetary Policy Committee. You are an accomplished economic researcher. Do these 

findings from both the Fed and from the various academics—do 

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12 

these findings seem reasonable to you that uncertainty about 

where monetary policy is going can, in fact, slow our economy and 

constrain credit availability? 

Dr. PLOSSER. Thank you. I think the answer is yes. They certainly make sense. I think there is a challenge in how you quantify 

those effects, but you can see the uncertainty showing up in a number of different situations. 

Think about the uncertainty of credit policy, about how much 

MBS was going to be bought and how much not. Were they going 

to rescue Lehman Brothers like they rescued Bear Stearns? Without articulating a policy that—strategy that guided those decisions, 

it resulted in uncertainty. The taper tantrum, as they said, that occurred. 

All those are examples of effects in the markets that came about 

through some uncertainty or through doubt about whether the Fed 

was going to follow through on some of its pronouncements. So I 

think it is very important that, yes, I think that uncertainty can 

matter. How and when it shows up is a bit of a challenge. But that 

just says that the Fed needs to be more strategic in articulating a 

strategy about how it is going to behave if certain things happen. 

Chairman BARR. Thank you. And, Dr. Levin, you, too, are an accomplished economic researcher. You have advised both Fed Chairman Bernanke and then Vice Chair Yellen. And in addition, you 

coauthored an article last year with the FED UP! Coalition’s campaign manager calling attention to the importance of transparency 

for our monetary policy authority, and acknowledgements for that 

article included Dr. Bernstein, who joins our panel today. 

The article called for the Fed to include in its Monetary Policy 

Report a discussion of any economic models and benchmark rules 

that are used in setting the course of monetary policy. Dr. Levin, 

does the discussion draft that you have before you today, the Monetary Policy Transparency and Accountability Act, does that bill as 

currently drafted as you see it effectively achieve that goal without 

mandating the FOMC to follow any particular mechanical rule? 

Dr. LEVIN. Well, thank you, Mr. Chairman. So, first of all, I just 

want to go back to something that Congressman Sherman mentioned before. The Fed serves the American public, and I think it 

is appropriate for Congress to think carefully about how to make 

sure the Fed is a fully public institution. That was the key point 

of the paper that we wrote last year. It is critical for the Fed to 

be diverse, regionally diverse, diverse in respect to the policymakers and the staff who are working at the Fed. Those are all 

critical issues that were in that paper. 

But on the specific issue, I think that—as I said before—clarity 

of a benchmark rule would help serve the public. It is related to 

your question to Dr. Plosser. It would help alleviate uncertainty in 

financial markets, and more generally businesses and consumers, 

the strategy the Fed is following. So I think it is appropriate in 

your draft legislation that the Fed have a simple strategy that it 

can explain to Congress and the public. 

Ideally, it would choose that strategy at the beginning of each 

calendar year. And of course, during the year, things might—unexpected things might come up, and then the Fed officials would explain if they need to change the strategy or deviate from the stratnshattuck on FSR297 with DISTILLER

13 

egy. So in that sense, I agree with you that this is a reasonably 

flexible approach that would help improve the Fed’s transparency. 

The Fed needs to have discussions among experts like Dr. 

Plosser was, with different points of view. Some people think that 

the Fed should continue to normalize. The policy rule that I 

showed you on the chart, it is not so clear, because if inflation 

stays around 1.3 percent where it is today, and output is just growing at a sustainable pace, then that rule would say that there isn’t 

necessarily such a strong case for the Fed to raise interest rates 

further at this point. 

But again, that is the sort of debate that should happen at the 

Fed. The Federal Reserve would choose the benchmark under your 

legislation. And it would be able to change the benchmark, but it 

could use that as a point of reference. And so I think this would 

be a very constructive way forward. 

Chairman BARR. Thank you. And I would like to ask the same 

question to the other two witnesses, but my time has expired, so 

we now move to the distinguished gentlelady from Wisconsin, the 

ranking member, Ms. Moore, for 5 minutes. 

Ms. MOORE. Thank you so much, Mr. Chairman. If I have understood the testimony we have had here today, it seems like there is 

not that much disagreement with regard to the Fed having taken 

the appropriate emergency lending authority. But then it seems to 

differ after that point. 

Dr. Bernstein, let me start with you. I am not trying to pick on 

you, Dr. Levy, but I just underlined some stuff in your testimony 

that I thought was very interesting. You thought that the economy’s lackluster response to the Fed’s stimulus highlights the important influences of other policies and factors, and you talked 

again about Dodd-Frank, the government tax and regulatory policies at both the State and local levels, in both the financial and 

non-financial sectors, the Fed paying interest on reserves, and saying that the banks just can’t lend, because they are just so burdened by regulations. 

Now, the banks are doing great, last time I checked. They are 

very profitable. And, Dr. Bernstein, I think we heard you say and 

talk about in your written testimony that we saw unemployment 

fall to 4.1 percent. What am I not getting here between the two of 

you? 

Dr. BERNSTEIN. Well, I think you raise some great points, and 

these thoughts came to mind listening to Charles Plosser also talk 

about the impact of Fed-induced uncertainty. In fact, unemployment is historically low. We are creating something like between 

150,000 and 200,000 jobs per month. That is a strong clip of job 

creation at this point in the cycle. I suspect all of my colleagues 

would agree with that. 

The GDP is growing slower than we might like. That is a function of low productivity growth. And I haven’t heard any convincing 

arguments that would connect Federal Reserve policy to that. So 

I think that if you are looking at economic conditions and you are 

trying to make a case that the Fed is somehow doing the wrong 

thing, you have a very high bar to cross. 

As far as the crisis goes, many of the policies that are taking a 

bit of a hit from my colleagues up here have been shown not only 

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14 

to be effective in pulling the recovery forward, but as I dictate in 

my testimony, looking at a wide spate of research, are associated 

with much quicker GDP growth, much lower unemployment, and 

including some of the bond purchases and emergency spending programs are associated with significantly lower interest rates in 

those sectors that clearly were important to growth. 

If anything, it is my view that is what has held back faster 

growth in terms of a policy setting was austere fiscal policy, not 

monetary stimulus. 

Ms. MOORE. Right, right, right. OK, so you talked about the— 

what if the Fed had been prohibited, as this legislation suggests, 

from purchasing Treasuries in response to the 2008 crisis, if we 

had the policy that would limit its purchases? What do you think 

would have happened? 

Dr. BERNSTEIN. Well, John Williams of the San Francisco Fed is 

I think a very highly respected empirical macroeconomist. He argued that the MBS purchases were, quote, the most effective part 

of the Fed’s asset purchase programs and that they, quote, ended 

up having kind of a bigger bang for the buck than the Treasury 

purchases. 

I quote research by Alan Blinder, former Vice Chair of the Fed, 

and Mark Zandi, highly respected economic researcher, that underscores Williams’ finding. Within a short time, they write, the MBS 

purchases by the Fed meant that, quote, homebuyers with good 

jobs and high credit scores could obtain mortgages at record low 

rates which helped end the housing crash. 

And in my testimony, I not only underscore those results, but I 

urge the committee to look at the potential for other asset classes 

that the Fed might be able to purchase, depending on the nature 

of the crisis. And I suggest municipal bonds might be one area to 

look at. 

Ms. MOORE. Well, the heart of the financial crisis was in the 

housing sector, so do you agree that that was good for the Fed to 

target that sector? 

Dr. BERNSTEIN. In a sense, we were, quote—and these are very 

big air quotes ‘‘lucky,′′ because the Fed, within its charter, was able 

to purchase assets from the very sector that took the hit, the housing sector. That might not be the case next time. 

Ms. MOORE. OK. Thank you. I think I will yield back the balance 

of my time, since we went over last time. 

Chairman BARR. The gentlelady yields back. The Chair now recognizes the Vice Chair of the subcommittee, Mr. Williams from 

Texas. 

Mr. WILLIAMS. Thank you, Mr. Chairman. And thank all of you 

for being here today. 

This subcommittee is grateful to have the testimony of so many 

of you, and we appreciate it, on a very important topic. As Vice 

Chairman of this subcommittee, I have been privileged to work 

with my colleagues and industry experts to ensure the Federal Reserve does not step beyond its intended purpose and authority and 

continues to play an independent role in monetary policy. I consider today’s discussion a pivotal step in the right direction. I look 

forward to working with the Chairman and distinguished members 

on these issues. 

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15 

So, Mr. Plosser, my question to you is, in March, you stated during an interview that you are concerned about preserving the fragility of independence as Congress considers reforms to the Fed. 

Now, based upon your previous role as president and CEO of the 

Federal Reserve of Philadelphia, do you feel that the reforms being 

considered today would help to maintain that independence? 

Dr. PLOSSER. Thank you, sir. I do. I think—as I talked about 

Treasuries and about political interference or political involvement 

of Fed and its own decisionmaking and pressures, both politically 

and by the public, I think it is very important that we separate 

clearly the responsibilities of the fiscal authorities from those of the 

monetary authorities. 

The more those responsibilities are blurred and overlap in some 

ways or have dual responsibilities, the harder it is to hold either 

party, Congress or the Fed, accountable for the decisions that they 

make. So it is really important, I think, to keep a line between 

monetary and fiscal policy. 

And one of the things I have argued is rather than undermine 

independence of Fed’s monetary policymaking, it would be better to 

narrow the scope of their responsibilities in a way that helped 

them focus on things that they can control and ultimately Congress 

wants them to do. So this separation between monetary and fiscal 

policy I think is an important aspect, and I think the way the bills 

are written and go to a Treasuries-only policy and to provide mechanisms for emergencies should they arise, it holds the right parties 

accountable at the right time. 

Mr. WILLIAMS. OK. Do you think there are any areas where you 

feel that the Fed is currently acting beyond its jurisdiction? 

Dr. PLOSSER. I can’t think of any right at the moment. I mean, 

they are beginning to unwind their balance sheet, as was said. I 

think—I wish they could do it a little faster, I think, because I 

think that is— 

Mr. WILLIAMS. Could you talk closer to the mic, please? Thank 

you. 

Dr. PLOSSER. Sorry. I think they are not doing anything immediately that is not appropriate. They are unwinding their balance 

sheet. I wish they would focus more on unwinding from the MBS 

and shrinking their balance sheet a little bit faster. In fact, I think 

that is actually more important right now than raising interest 

rates. 

Mr. WILLIAMS. OK. Mr. Levy, thank you for being here today. In 

your testimony, you acknowledged—rightfully so—that the actions 

of the Fed following the economic crisis have, in your words, extended the role of monetary policy beyond its normal scope. You 

say that the Fed’s position that QE3 was responsible for increases 

in employment and economic expansion reflect a great deal of hubris. 

I would tend to agree with you. Do you agree with the characterization that the purchase of mortgage-backed securities by the Fed 

is a dangerous long-term strategy? 

Dr. LEVY. Yes, I agree. Particularly we have—once again, the 

Fed’s original purchases of MBS, November 2008, was as Chairman Bernanke said, an absolute emergency. The MBS market was 

frozen and really threatened the global financial system. 

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16 

We are no longer in an emergency. Financial markets are normal. Mortgage markets are normal. Housing market is doing just 

fine. Why is the Fed the largest holder of MBS in the world? It just 

absolutely doesn’t make any sense, and it is not a good long-run 

strategy. 

So once again, I think we need to distinguish between the proper 

role of the central bank during an emergency and the proper role 

during normal times. And we are certainly in normal times now. 

Mr. WILLIAMS. OK, let me ask you another question. Will the 

proposals before us help to successfully unwind the excessively 

large balance sheet of the Fed, do you think? 

Dr. LEVY. Excuse me, sir. I didn’t—maybe I didn’t hear— 

Mr. WILLIAMS. Yes, will the proposals before us help to successfully unwind the excessively large balance sheet of the Fed? 

Dr. LEVY. It won’t hurt it, but it doesn’t directly address it. I 

mean, so right now, the Fed’s strategy for unwinding its balance 

sheet ever so gradually and passively effectively involves reinvesting all but about 97 percent of MBS and Treasury holdings, 

this very gradual unwind. 

And it is a step in the right direction, but I think it should be 

more aggressive, because once again, I don’t think the Congress or 

the Fed are really considering some of the risks involved, but not 

just the Fed stepping over the bounds into fiscal policy, but there 

are just massive risks, including the risk that Congress thinks of 

this as risk-free money to spend. And that is very dangerous. 

Chairman BARR. The gentleman’s time has expired. 

Mr. WILLIAMS. Thank you, Mr. Chairman. 

Chairman BARR. Thank you. The gentleman’s time has expired. 

The Chair now recognizes the gentleman from California, Mr. Sherman. 

Mr. SHERMAN. Mr. Chairman, I want to thank you for putting up 

a quote from Congressman Brad Sherman when it was your time. 

I can think of no more credible analyst. And you quote me to say 

that Section 13(3) is still a dangerous code section. 

Dr. Bernstein points out that because of the other provisions of 

Dodd-Frank, it is less likely to be needed, which means it is less 

likely to be abused, but it is also less likely to be necessary. So the 

question then is, how can we make it even less likely to be necessary? And first thing we should do is break up the too-big-to-fail. 

Too-big-to-fail is too big to exist. And we should never have a circumstance where the Fed is tempted to use 13(3) or to come to us 

for emergency legislation, as they did successfully in terms of passing their legislation, by saying, look, if this one entity goes under, 

it is taking the entire economy with us. 

I would point out that one thing that 13(3) does not have is a 

dollar limit. I remember when the chair of the Fed was here and 

I proposed either a $4 trillion or an $8 trillion limit, and the Fed 

chair would not go along with that, that was at a time when it 

wasn’t being used at all. So it is—clearly Congress should be consulted at some stage. 

Mr. Plosser, you point out that we should not use 13(3) to help 

any one individual or company. There is a constant debate in our 

society between democracy and rule of the philosopher-king exnshattuck on FSR297 with DISTILLER

17 

perts. You would think that democracy had won that debate. I am 

by no means sure. 

I think that there is general agreement that the people of the 

country can elect politicians, so long as those politicians don’t control anything that is thought to be really important, and that if 

politicians do, that process is known as politicization of what actually the philosopher-kings should control. 

Mr. Levin, you point out that the Fed shouldn’t suffer from second-guessing. Welcome to Washington, D.C. I don’t think there is 

a member of this committee who is not second-guessed on everything they do at all times. And the financial press seems to exist 

for the sole purpose of second-guessing the Fed. 

Speaking of whether the Fed is predictable or not, they are absolutely and totally predictable within one quarter of 1 percent. That 

is pretty good. Reasonable minds on the Fed can differ to the extent of one quarter of 1 percent. They are far more predictable than 

anything else I am aware of. 

The problem with the Fed balance sheet is that they are shrinking it when they should be growing it. You can say there is no crisis, but wages remain stagnant. That leads to divorce. It leads to 

drug abuse and opioid abuse. It leads to broken families. It leads 

to a host of problems that we would not have otherwise. And so it 

may not be a crisis for the whole country, but it is a crisis for millions of families. 

Let’s see. So I want to focus—since I have Dr. Bernstein here, 

on the tax provisions. We were talking about those earlier. Oh, and 

I do want to thank, as long as the—I mean, the majority has put 

my quote up on the board knowing that I should follow their lead. 

I have also put my own material up on the board. 

And I want to point out that the abandonment of quantitative 

easing is going to cost our Treasury between $80 billion and $100 

billion a year. And we live in this strange world where almost everyone except our witnesses are unaware—and maybe some of our 

members are unaware—that this money is coming into the Treasury. And then our witnesses live in a world where that is shameful, 

because it is unintended, because that isn’t the purpose of the entity. I would say that if you were in the private sector and your byproduct starts making you huge amounts of money, that creating 

the byproduct becomes one of the purposes of the company. 

But, Dr. Bernstein, did the models on the effect of this tax law, 

do they deal at all with the increase in the trade deficit due to the 

strengthening of the dollar due to the increase in Federal borrowing? 

Dr. BERNSTEIN. I know my time is up. I will answer you with one 

sentence. The theory of the case on the tax cuts is that the cut in 

the corporate rate will draw in capital flows from abroad, and those 

will increase the trade deficit. 

Chairman BARR. Gentleman’s time is expired. The Chair now 

recognizes the gentlelady from Utah, Mrs. Love. 

Mrs. LOVE. Thank you. Thank you all for being here. In previous 

hearings regarding the Fed and monetary policy, we had discussions about the Fed being just as bad as everyone else at economic 

and financial forecasting, despite having an army of PhD economists running complex computer models. 

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18 

Why do you think the Fed is so bad at forecasting? And I was 

wondering if I can get your thoughts on that, Dr. Plosser. 

Dr. PLOSSER. I think that economists in general are not that 

great of forecasters. That is just the reality of it. Many of the 

things that go wrong with forecasts are the things that—are events 

that occur that weren’t forecastable and therefore cause problems. 

I also think that actually raises the importance of the distinction 

between what we might call a rules-based strategy and a discretionary strategy. Discretionary strategy says the Fed will do what 

it wants to do when it wants to do it for reasons that it feels it 

wants to, OK? That is very unpredictable as to how that is going 

to respond. 

Mrs. LOVE. Right. 

Dr. PLOSSER. But the future is uncertain. Always has been uncertain and will continue to be uncertain. The value of many of the 

rules-based strategies and the strategies where you articulate, well, 

what will the Fed do if this or this happens? Right? 

Mrs. LOVE. Right. 

Dr. PLOSSER. That reduces uncertainty. You don’t have to guess 

what the Fed will do. It won’t make up new reasons for doing the 

thing it is doing. It will be a bit more predictable. 

Mrs. LOVE. OK. 

Dr. PLOSSER. Because the future is predictable. 

Mrs. LOVE. Right. 

Dr. PLOSSER. So I think that we have to just accept the fact that 

the future is unpredictable and think about strategies that allows 

the Fed to operate in an unpredictable world in a predictable way. 

Mrs. LOVE. OK, I am glad you said that, because I am trying to 

figure out a way to do that. So according to former Federal Reserve 

Board Governor Kevin Warsh, currency stability is one of growth’s 

best friends. He also worried that the Fed’s extraordinary tools encouraging businesses to favor financial engineering over capital investment and consequently weakened growth in business investments is providing to be an opportunity killer for workers. 

Do you agree with that assessment or disagree with that assessment? Yes, I am still sticking with you. Yes. 

Dr. PLOSSER. I apologize. I am sorry. I thought you were talking 

to Dr. Levin. 

I agree with most of it. I do think that many of us said during 

both very low interest rate period when we reached zero and during quantitative easing that much of the effects of those efforts 

were absorbed in financial re-engineering by companies, restructuring corporate debt policies, and one of the big puzzles for the recovery and one of the reasons it was slow was the fact that real 

business investment didn’t grow like it had in previous recoveries. 

It wasn’t as responsive to the typical tools of monetary policy. 

We saw this effect in financial re-engineering, restructuring of 

debt, so forth and so on. So I think there is—I share a lot of the 

concerns in that statement. 

Mrs. LOVE. OK, I want to get to Dr. Levy, because we have had 

an opportunity to discuss this before. You and I have talked in previous hearings about the relationship between monetary policy and 

employment. And why do you think that the Fed’s policies have 

been such a boom for what Kevin Warsh has referred to as finannshattuck on FSR297 with DISTILLER

19 

cial engineering, while leaving too many Americans underemployed 

and barely able to make ends meet? 

Dr. LEVY. This is a great question. So getting back to Dr. 

Plosser’s comment, and Kevin Warsh’s comment, it is critically important to point out that while the Fed was very successful in lowering the real cost of capital, businesses didn’t respond. And they 

didn’t respond for a host of non-monetary reasons, including tax 

and regulatory policies. 

Now, to your point on employment, there are so many factors affecting employment and wages that go so far beyond monetary policy. Productivity has been slow. This should be a subcommittee on 

education, because let me give you an important statistic. Eightyfive million people, working-age population, have a high school degree or less. Wages tend to be low. Monetary policy can’t do anything about it. 

OK, so—and you could go through a host of other government 

regulations. So this is why I am emphasizing that we all want 

higher standards of living. The issue is, what is the proper role of 

monetary policy? So the Fed could add on QE3 and QE4 and up 

to a zillion, and it is just not going to create the type of employment gains and wage gains that we all really want. 

Chairman BARR. The gentlelady’s time has expired. 

Mrs. LOVE. Thank you. 

Chairman BARR. Gentlelady’s time has expired. The Chair now 

recognizes the gentleman from Arkansas—the Chair recognizes the 

gentlelady from Wisconsin? 

Ms. MOORE. Yes, thank you so much, Mr. Chairman. Excuse this 

interruption. I would like to ask unanimous consent to place a 

statement in the record from Better Markets. There was a quote 

attributed to them taken from a release issued in 2015 when the 

Warren-Vitter bill was introduced. And they just want to clarify 

the differences in that bill and what is being offered here today, 

just for the record. 

Chairman BARR. Without objection. So the statement will be entered into the record. And the Chair now recognizes the gentleman 

from Arkansas for 5 minutes. 

Mr. HILL. I thank the Chairman. Appreciate you and Ms. Moore 

convening this hearing. And thank our excellent panel. Appreciate 

all of your participation, as well. 

This subject of Federal Reserve independence from credit policy 

is not new to this subcommittee, and so I am glad we are continuing this discussion. As Marvin Goodfriend, a professor of economics at Carnegie Mellon, said in 2014, I think it was—he summarized it nicely, said flexibility and decisiveness are essential for 

effective central banking. Independence enables the central bank to 

react promptly to macroeconomic or financial shocks without the 

approval of the Treasury or the legislature. Central bank initiatives must be regarded as legitimate by the legislature and the 

public. Otherwise, such initiatives will lack credibility essential for 

their effectiveness. 

The problem is—which is what we are talking about today—to 

identify the limits of independence on monetary policy and credit 

policy to preserve a workable, sustainable division of responsibilities between the central bank and between the fiscal authority. 

nshattuck on FSR297 with DISTILLER

20 

And I think that is really at the heart of what we are talking about 

today. 

And if we have an efficient monetary policy, then it helps our private markets allocate goods and services, most readily—finding 

their most promising opportunity. And if we engage in what we 

have done over the past 10 years, we really skew the price mechanism and skew investment. So I really appreciate your testimony, 

all of your testimony. 

We have seen around the world unprecedented accommodation, 

not only here in the United States, but in central banks around the 

world, where I think Japan now is somewhere approaching 100 

percent of GDP with the size of its balance sheet, and we are at 

about a quarter of our GDP. And in Europe and in Japan particularly, we have $12 trillion, $13 trillion of sovereign debt at negative 

interest rates. And we have some of those central banks buying 

corporate debt and equity obligations, something that we have certainly been concerned about here. 

So I do think, as the Ranking Member noted, that there are concrete reasons why we are having this testimony and thinking about 

why those distorted price signals and the mixing of credit and monetary policy are not a good thing for our country. 

Dr. Plosser, in talking about Treasury-only, I want you to emphasize that we have 40 percent of the new issue MBS owned by 

the Federal Reserve right now. We have about 15 percent of the 

Treasury market, more or less, since the crisis. And I think—last 

time I looked at their statement, they own 4 percent of other, 

which includes Maiden Lane, which I guess is the residual detritus 

of Bear Stearns. 

Your concept is that we just simply—whether it is a 13-D action 

or any other action, if we the Fed take on a non-Treasury asset 

that in some reasonable amount of time we ask the ultimate fiscal 

authority of the Treasury to take that and swap Treasuries back 

to the Fed, isn’t that what we are talking about? 

Dr. PLOSSER. That is the essence of it, yes, Congressman. 

Mr. HILL. So that doesn’t—it doesn’t per se that—and I agree 

with Dr. Bernstein. We have to be very careful in how that is done 

and the timeframes and we don’t want in a crisis to make things 

more difficult. But the ultimate issue is that the Treasury, just like 

if it hadn’t done a very effective job in getting rid of their final 

TARP assets, they would be liquidating Maiden Lane and not leave 

that over at the Fed. Isn’t that an example of what you are talking 

about? 

Dr. PLOSSER. That is essentially what I have been arguing, exactly that. 

Mr. HILL. And— 

Dr. PLOSSER. And by the way, there was a memo written between the Treasury and the Fed back in—it was in 2009, where 

there was an understanding that the Treasury would do everything—because this discussion started way back then—that the 

Treasury would do everything it could to relieve the Fed of those 

private-sector assets, recognizing that they were really the responsibility of the fiscal authorities. 

That never happened, obviously. And so I think this is really 

about the process of restoring the Fed so it can continue to conduct 

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21 

monetary policy in a manner that is appropriate without—with 

Treasuries, rather than trying to deal with the Maiden Lanes of 

the world. 

Mr. HILL. Well, not only be neutral between the private markets 

on that credit allocation and monetary policy, but also put the fiscal authority, which is under the purview of the Congress, into 

whether we are going to spend money on one thing or another to, 

quote, intervene in markets in the time of a crisis. I think you 

make a good point. I yield back, Mr. Chairman. 

Chairman BARR. Gentleman yields back. The Chair now recognizes the gentleman from Minnesota, Mr. Emmer. 

Mr. EMMER. Thanks to the Chair. And thank you to this great 

panel for being here today. 

I want to followup on Mrs. Love’s questions relating to Kevin 

Warsh’s quote about financial engineering. And, Dr. Levy, since 

you were on this when the time ran out, can you give me some examples of the types of financial engineering that Mr. Warsh was 

referring to? 

Dr. LEVY. Quite simply, by keeping rates at zero, so the cost of 

capital is zero, that gives companies the flexibility to alter their liability structure, alter their capital structure in any way. And the 

problem you run into is when you are running a company, and 

your Treasury Department starts making too much money, and 

your basic business isn’t, things aren’t good. 

I hate to say this in such lay terms, but if it becomes so financially advantageous to take advantage of the current financial system to generate profits, then you take your eye off your basic business ball. And I think a lot of that happened. 

So once again, if we go back to what the Fed tried to do and was 

very articulate about in—say, its QE3, Chairman Bernanke when 

he rolled it out says, OK, QE3, we want to pump a huge amount 

of excess liquidity into the economy, keep rates very low, and 

through forward guidance convince markets we are going to keep 

rates really, really low for a really long time. We want to encourage 

risk-taking and push up asset prices, and all of that is going to 

stimulate aggregate demand. 

It did all of that, but it didn’t stimulate aggregate demand. Once 

again, I will emphasize, I understand employment went up, but 

nominal spending growth in the economy didn’t accelerate. And so 

when economists talk about distortions, you can drill down to what 

it means for household decisionmaking and business decisionmaking. 

Mr. EMMER. So what do you think the Fed should be doing to encourage capital investment and job creation instead of this financial engineering? Instead of making too much money through the 

Treasury? What would a better approach be? 

Dr. LEVY. Well, I think the Fed should proceed to normalize interest rates, and that means raising rates right now toward 3 percent. I don’t think it should—which would mean 1 percent real 

rate. I don’t think it should be sidetracked from that due to low inflation or any international whatever should come up. 

And I think on its balance sheet, the Fed should, once again, proceed with a strategy to unwind all of its mortgage-backed holdings 

over, say, a period of 5 years, which is reasonable. You could do 

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22 

most of it passively. You wouldn’t have to sell any. And to basically 

normalize policy and set the record straight about what the proper 

scope of monetary policy is, and I think that would reduce uncertainty and build confidence in the private sector. 

Mr. EMMER. Well, that is interesting, your last statement, because my next question was, in your opinion, has the Federal Reserve done a sufficient job of announcing to the American people 

a clear and consistent strategy on how it plans to spur economic 

growth? 

Dr. LEVY. The Fed’s tried to be transparent, but because it has 

not had a strategy, it is very difficult to be clear. And so while they 

talk about transparency, their message oftentimes gets muddled 

without a strategy. And so once again, I think the Fed should— 

during a healthy economic period, it should stick to its monetary 

knitting and not try to get itself involved in fine-tuning the economy and giving mixed signals to markets. 

And I do think the Fed’s forward guidance during parts of this 

economic expansion, expressing worries that even a 25 basis point 

hike in rates could generate the next recession, it is certainly not 

a positive for confidence. 

Mr. EMMER. It is not helpful. Thank you. I yield back. 

Chairman BARR. Gentleman yields back. The Chair recognizes 

the gentleman from Indiana, Mr. Hollingsworth. 

Mr. HOLLINGSWORTH. Well, good afternoon. I appreciate everybody being here. It is a rare day when you face four doctors sitting 

across from you. Consider it a pleasant experience, right? 

But I wanted to talk a little bit more about what has been discussed already. And I think that one of the challenges here is—on 

both sides of the aisle is confusing the counterfactual a little bit. 

We say, oh, growth is non-zero, thus things are going great. Bank 

profits are greater than zero, thus things are going great. 

But I think the literature looking back on this shows how loan 

growth has been severely constrained compared to coming out of 

previous recessions. And so one of the things that I wanted to talk 

about was interest on excess reserves and how that may be slowing 

banks’ willingness to make loans to other creditworthy borrowers 

and to mobilize those loans into capital investment loans. 

As you well said, Dr. Levy, that investment has certainly been 

sub-par compared to previous expansions. And I guess in my view, 

and maybe this has gone out of fashion, but in the super long run, 

it is productivity that generates economic growth. And monetary 

policy has the ability to move things around on a temporary basis 

or on a short-term basis, but ensuring that we ultimately create a 

more productive work force, so we create more productive uses for 

capital is hugely important. I wonder if you could talk a little bit 

about how interest on excess reserves may be constraining those 

investments. 

Dr. LEVY. OK, so the Fed pays interest on excess reserves, and 

for—they put this in place in October 2008. And for a large portion 

of the period recently, that interest they pay on excess reserves has 

been above the effective funds rate, and therefore that is—it is one 

factor but not the only factor that has probably constrained bank 

lending. 

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23 

I would also note another factor here is that the Fed stress tests, 

while they have been successful in leading particularly large banks 

to raise their capital adequacy standards, I can tell you when bank 

executives deal with stress tests all day long— 

Mr. HOLLINGSWORTH. Their stress goes up. 

Dr. LEVY. —they are in no mood to make a loan. And the lenders 

down the hall say I don’t want to make this loan because the risk 

of making a mistake is very, very large. So I think it all adds up 

to— 

Mr. HOLLINGSWORTH. If you have a regulatory environment that 

dampens loan growth, and then you have the ability with no 

counterparty risk whatsoever to earn above market rates at the 

Fed, why take on risk without any apparent gain? Right? And, Dr. 

Levin, I was hoping that you might comment on that, as well. 

Dr. LEVIN. Well, I think I agree with you that the interest on reserves was, you know, granted by the Congress to the Federal Reserve at a time when banks were earning zero interest. And that 

was viewed as a distortionary cost that was discouraging banks, 

and effectively disintermediating funds from the banking system 

elsewhere, because banks are required to hold some reserves at the 

Federal Reserve. 

This is a crucial question. I think that a part of the solution to 

this in my view is that Congress should authorize the GAO to do 

comprehensive annual reviews of all aspects of the Fed, including 

in the monetary policy—including interest on reserves. I think 

there is a real question in my mind why the Federal Reserve is 

paying a significantly higher rate on interest on excess reserves 

compared to, say, the rate in the repo market or the Treasury bill 

market. 

Mr. HOLLINGSWORTH. It is certainly something on our minds, as 

well, as we continue to focus on that. Obviously, what we want is 

capital mobilized in the real economy to make investments, privatesector investments such that productivity will grow over the long 

run so that we can realize those benefits as Solow predicted. 

Anything that you wanted to add to that, Dr. Plosser? 

Dr. PLOSSER. So I agree with what is been said, but I would like 

to go back to the beginning of your statement and remind everybody that one of the dangers that we slipped into during this period—and oftentimes do—is relying on the Fed to be the solution 

to all our economic problems. And it is not, and it can’t be. 

The real key to economic growth is productivity. Productivity of 

the work force— 

Mr. HOLLINGSWORTH. Productivity generated by private capital 

making investments, continuing to grow the economy. 

Dr. PLOSSER. And the Federal Reserve cannot determine that. 

Mr. HOLLINGSWORTH. I think that is well said. 

Dr. PLOSSER. And I think—well, you said it. I was just reiterating how important I think it is. 

Mr. HOLLINGSWORTH. You know what? I like that even better. 

And I think the addiction to Federal Reserve intervention, especially as you well said during positive times of economic growth, 

continues to endanger their ability to come to any sort of help during periods of great acute stress. 

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24 

Dr. PLOSSER. This is the most interventionist Fed in private markets, even today, than it has been in the last 50 years, at least. 

Mr. HOLLINGSWORTH. Thank you, Dr. Plosser. I yield back. 

Chairman BARR. The gentleman’s time has expired. The Chair 

now recognizes the gentleman from Ohio, Mr. Davidson. 

Mr. DAVIDSON. Thank you, Mr. Chairman. And I want to thank 

our guests. I really appreciate your testimony here and in writing. 

And I have learned a lot from some of your other writings. 

So, Dr. Plosser, could you elaborate on some of the real economic 

opportunities for American households and businesses should they 

benefit from monetary policy framework that drew a brighter line 

between accountability for fiscal and monetary policy? 

Dr. PLOSSER. Well, I think there are a couple of ways to think 

about that. One, it is separating roles and responsibilities and accountability. I think in many cases, households are worried a lot 

about what the Fed’s going to do next and what it is going to do 

to interest rates. And frankly, I believe the Fed is not as powerful 

over interest rates and the real economy as people seem to believe. 

If you remember, when the Fed began tapering and stopped buying assets, it was because it was concerned about interest rates, 

long-term interest rates were going to rise. They didn’t. They fell 

for about a year. So I think that this fixation on the Fed’s ability 

to control productivity growth, real wages, lots of other things is 

overblown and that we need to scale back those expectations and 

look for things that focus on productivity that can make the economy grow. And that is what is going to make the real lives. 

The contribution of the Fed is going to be mainly keeping inflation low and stable. Alan Greenspan used to say that is—when inflation becomes a non-issue for people’s lives, then we are doing 

OK. 

Mr. DAVIDSON. Terrific. One of the things that have made inflation such a constraint thing hasn’t really been monetary policy, but 

it has been the strength of the dollar and the power of trade. Some 

of those dynamics that have taken place—of course, some of that 

has led to challenges to the U.S. as the de facto reserve currency. 

Dr. Levin, I was wondering if you could comment on that, as a 

future challenge, and what role the central banks—in this case, the 

Fed in particular—could play? 

Dr. LEVIN. Well, I think that the Federal Reserve is the most important central bank in the world for sure. And it is not just Americans who want to understand better what the Federal Reserve 

does. It is true all over the world. Other central banks are also trying to understand what the Fed’s decision is and what its strategy 

is. 

So I just—I want to come back to this question about strategy 

for a second. I think one way to think about this—the purpose of 

the legislation you are adopting today is maybe relatively innocuous during normal times. Some of it is specifically directed toward 

emergency credit and toward actions that would happen in an 

emergency. 

Even the benchmarks—I think during normal times it is true 

that the—for example, the Federal Reserve barely changed the 

Federal funds rate for a number of years in the 1990’s when the 

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25 

economy was on a steady course. I think the purpose of this legislation is to have it in place the next time around. 

What are the contingency plans the Federal Reserve is going to 

follow? Those should be clarified in advance. I remember, I was at 

the Fed at the time. People referred to it as throwing spaghetti at 

the wall to see what sticks. And that is not an appropriate thing 

to do. It is important for Congress to understand ahead of time 

what the Federal Reserve is going to do in an emergency. 

The strategy for monetary policy I think of as a little bit like a 

patient who is a child, and you are the patient’s family in some 

sense who needs to consult with a team of doctors that you respect 

and trust, but you want to consult with them and understand the 

strategy that is being followed. The strategy. It has to be one strategy. 

And it is absolutely true, the economy has lots of uncertainty. 

Someone asked earlier about forecasting. But a good team of doctors are going to say, look, here are some risks, we have to take 

seriously those risks. If this materializes, here is the action plan 

we are going to take. And so those are the sort of things I think 

you are asking the Federal Reserve to start doing. 

Again, it is not hawkish or dovish. It is good governance here 

and accountability and transparency. It will help the world economy— 

Mr. DAVIDSON. Correct. And so I agree. And I think the challenge, when you talk about the Emergency Lending Act, when you 

look back, so this was forward-looking. Now, if you say—well, let’s 

say there is this accountability and we have to check. What do you 

see the implications of a potential reversal with the congressional 

accountability to say, you have done emergency lending, we think 

that was a bit of an overreach. What do you see as the implications 

for that level of accountability? 

Dr. LEVIN. OK, so the critical thing, again, just use this analogy 

with the patient and the patient’s family and the doctors. Try to 

consult ahead of time so that by the time when the operation— 

again, I strongly believe you can’t micromanage the Fed. It has to 

be able to make decisions on a day-to-day basis. But what the Federal Reserve should be doing is consulting in advance to say if this 

happens, we may need to carry out this emergency procedure. And 

the patient’s family gives a directive to say, OK, we can live with 

that. 

So the up-or-down vote that this legislation is proposing hopefully what would not happen is a panic, but what would hopefully 

be happening is, oh, OK, the risks are increasing, we need to 

launch this emergency facility, and Congress says, yes, you have 

been explaining that to us for a number of months or years, and 

we are comfortable with your going ahead. 

Mr. DAVIDSON. Thank you. My time has expired. I yield back. 

Chairman BARR. The gentleman’s time has expired. The Chair 

recognizes the gentleman from West Virginia, Mr. Mooney. 

Mr. MOONEY. Thank you. My question is primarily aimed at Dr. 

Levin. And first, go big green, Dartmouth class of 1993 here. I will 

be heading back for my 25th reunion this summer. Maybe I will 

see you up there. 

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26 

But you have touched a theme that has been of concern to me 

for a while of Congress delegating, giving up, just receding its authority to Federal administrative branches. I see that in a lot of 

places, not just with monetary policy. I see it with environmental 

policy in my State of West Virginia. I have seen it with—gosh, even 

declaring war on foreign countries, going to war in foreign countries. I mean, we are seeing it a lot of places. And I think Congress 

needs to reassert itself. 

In the written testimony, I want to reference the written testimony from Mr. Bernstein, where he emphasized the importance for 

Congress to maintain central bank—for Congress to maintain central bank independence and, quote, efficient functionality, close 

quote. So, Dr. Levin, does the draft legislation that you reviewed 

for the hearing—do you believe it compromises monetary policy 

independence or compromise efficient functionality, as your colleague has expressed a concern about? 

Dr. LEVIN. OK, look, there is the broader picture and then there 

are the details. Let’s just start with the broader picture. That is 

why I started with the exhibit. Basic management principles. The 

Congress has to be the boss. The Federal Reserve is not an independent branch of government. It reports to you. And it is absolutely essential for you who are elected officials by the public—I 

agree with what Congressman Sherman said before. You are the 

ones who are elected by the public to oversee the Federal Reserve. 

It cannot be truly absolutely independent. It has to be conditionally, operationally independent. 

Now, I think this draft legislation at a fundamental level is consistent with the operational independence. In fact, I think, as Dr. 

Plosser said, I think it would strengthen in some ways the operational independence of the Fed. 

There are details of some of these things about how many days, 

for example, before the congressional approval has to be given, 

which exact types of securities under which conditions can be purchased. I hope that—I understand that your committee is going to 

be marking up this legislation next week. It seems to me that there 

may be some room for consultations and compromises, as you always do. But, again, this seems to me as a matter of good governance and transparency and accountability, and I hope there is a 

way forward to enact this. 

Mr. MOONEY. OK, thank you. Mr. Chairman, I will yield back. 

Give my time back to the Chair. 

Chairman BARR. The gentleman yields back. The Chair recognizes the gentleman from North Carolina, Mr. Pittenger. 

Mr. PITTENGER. Thank you, Mr. Chairman. And thank each of 

you for being with us today. It is an honor to have you join this 

committee. 

I would like to follow up, if I could, on some of Mr. Williams’ 

questioning. Mr. Levy, if you could just expand further on what you 

believe to be the economic risks that are created by maintaining a 

balance sheet of the current size? 

Dr. LEVY. There is economic and interest rate risk, and there is 

also political risk. As far as the economic risks go, the Fed at its 

peak remitted about $115 billion, I think in Fiscal Year 2015. Now 

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27 

it is remitting about $85 billion. It is paying IOER, and bond yields 

have come down some. 

This crosses the monetary boundary of policy into fiscal policy. 

If it sounds OK because it reduces the budget deficit, but that is 

temporary, and it is very risky, because as I noted, if interest rates 

rise by 1 percent, which is very consistent with the Fed’s expectation that rates are going to rise, and inflation is going to go to 2 

percent, then that is going to add $1.6 trillion to the deficits. And 

so that is a risk. 

The other risk is political. And that is it is too easy for Congress 

to look at this as risk-free money and to spend it, and to look at 

the Fed as a source of risk-free money. And doesn’t this jeopardize 

the independence of the Fed? And Dr. Plosser pointed out that in 

December 2015, the Fed—in order to pass the FAST Act, the Congress actually borrowed some of the—took some of the Fed’s assets. 

And this is just inappropriate. It is an inappropriate use of monetary policy. 

And so the Fed by doing what it is doing has these political and 

economic risks. And it is kind of egging on the Congress to take 

advantage of it in bad ways. 

Dr. PLOSSER. Excuse me, can I— 

Mr. PITTENGER. Please, Dr. Plosser. 

Dr. PLOSSER. —elaborate a little bit as an example? The danger 

is—with the last time I testified here last year one time, I got 

asked, well, why shouldn’t the Fed fund our infrastructure projects 

by blowing up their balance sheet some more? There is a real problem in many central banks around the world with exactly that. 

The Bank of Switzerland, for example, has a very large balance 

sheet. It is mostly made up of foreign reserves, currency reserves. 

They are in a deep political battle because some parties within 

Switzerland want to use that balance sheet to invest in green energy, Swiss companies, other types of activities in the name of diversifying the Swiss National Bank’s balance sheet. 

If the Fed maintains a large balance sheet that is not tied to 

monetary policy, the use of that balance sheet can—the temptation 

to use that for other purposes is going to be great. And I think the 

idea of shrinking the balance sheet and tying it to monetary policy 

will constrain that activity and actually protect the Fed from 

abuses and prevent it from undertaking its own abuses of its balance sheet. 

Mr. PITTENGER. Yes, as a follow up, would you say, then, that it 

is time for the Federal Reserve to get out of the business of engaging in credit policy? 

Dr. LEVY. Yes. The Fed should set out a strategy to wind down 

its MBS holdings. There is no reason at all for the Fed to hold 

MBS, unless in an emergency situation. And it can do so over, say, 

a 5-year period through passively unwinding the portfolio in order 

to give the mortgage market time to adjust. It need not sell any 

to do that. 

Dr. BERNSTEIN. Can I make a quick comment, if that is OK? 

Mr. PITTENGER. You can. 

Dr. BERNSTEIN. Any time the Federal Reserve engages in monetary policy, it is raising or lowering interest rates, and that is credit policy. So I am not sure I understand this distinction at all. 

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Chairman BARR. The time is—I am sorry. 

Mr. PITTENGER. Quickly. 

Chairman BARR. Quick answer. The time of the gentleman has 

expired. So quick answer. 

Dr. LEVY. OK. The quick answer is the Fed by holding MBS securities is specifically biasing the mortgage market at the expense 

of other credit markets. 

Mr. PITTENGER. Thank you. My time is expired. 

Chairman BARR. The gentleman yields back. The Chair now recognizes the Chairman of the Capital Markets Subcommittee, the 

gentleman from Michigan, Mr. Huizenga. 

Mr. HUIZENGA. Thank you so much. Sorry, I was a bit late earlier. I was—actually had a couple of bills on the floor that we were 

moving forward with. And those duties kept me there. 

Before I launch into it, I thought it was interesting, the Ranking 

Member submitting a statement from Better Markets rebutting 

themselves, basically a situation where they believe found themselves inadvertently supporting us and what we are doing. And 

heaven forbid. We wouldn’t want to actually come to consensus and 

move forward on something. 

So whether it is Warren-Vitter or Barr-Moore, I don’t care. Whatever the title and label might be, let’s get some of these things done 

that have broad, wide consensus, and not be political about it. So 

off of my soapbox on that. 

Dr. Levy, just want to touch base. Obviously, you watch financial 

markets around the world and on a regular basis and see the real 

effects, how monetary policy increases those spreads and decreases 

economic growth. You have talked about this in the past, and I am 

curious if you could just comment how important it is for this legislation to sustain or even improve upon the stronger economic data, 

which we have seen over the last couple of quarters. 

Dr. LEVY. I think by normalizing monetary policy it would take 

away the monetary crutch from the economy and financial markets. It would not harm the economy, and it would lead financial 

markets to be much healthier. The other point I would add is by— 

and here I just applaud what Dr. Levin has emphasized—if the Fed 

actually had a single, understandable, and cogent strategy, it 

would certainly make it easier for the Fed to convey that message. 

It would build confidence. 

And once again, the proper role of the Fed, we have seen it go 

far beyond its scope. Its discretionary policy has created uncertainty. And I would really like to see more of a strategic approach 

that lays that foundation for the economy to grow at a healthy 

rate. And financial markets adjust. 

Mr. HUIZENGA. I think many of us are looking forward to just the 

strategy as you just laid out. Dr. Plosser, good to see you again. 

And I want to talk a little bit about your article you wrote for the 

Hoover Institute entitled ‘‘Why the Fed Should Only Own Treasuries.’’ And that article, I want to quote you, if that is all right. 

‘‘History teaches us unless governments are constrained constitutionally or by statute, they often resort to the ‘printing press’ to 

avoid making tough fiscal decisions. But in a democracy, independence must come with limitations on the central bank’s authorities 

and discretionary powers. Otherwise, central bankers can use their 

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29 

powers to venture into policy realms unrelated to monetary policy, 

especially fiscal policy, which more appropriately rests with elected 

officials.’’ 

And as you know, obviously those Fed balance sheets not only increased in size during the financial crisis, they added large quantities of non-Treasury securities, I think as you put it. Your article 

highlights that the more troubling loans under Section 13(3) that, 

quote, ‘‘amounted to debt-financed fiscal policy without the explicit 

authorization of Congress.’’ 

So, Dr. Plosser, in your opinion, what are the downside risks of 

blurring these lines of accountability for monetary policy and fiscal 

policies? 

Dr. PLOSSER. Well, I think as we have been talking off and on 

this afternoon, it is that blurring that is dangerous. Because what 

that does is confuses both in the eyes of the fiscal authorities and 

the monetary authorities and the public who is responsible for 

what. And who do we hold accountable for what? 

And when you put taxpayer money at risk and you buy portfolios 

of private assets on the banks’ part, you are, in fact, putting taxpayer money at risk. And you are investing in whatever it happens 

to be, MBS mortgage portfolios or whatever happened to be on the 

balance sheet that the Fed chose to buy, you are taking fiscal actions. 

Mr. HUIZENGA. Is your concern sort of a winners versus losers? 

And these governments kind of picking it? Or just in general, and 

I am a huge fan of the Swiss normally, but I hope that they don’t 

head in the direction that you described. 

Dr. PLOSSER. Well, they are getting pressure to head in that direction. That is absolutely true. 

Mr. HUIZENGA. Yes, and we have had that. And the downside of 

that seems—we are allowing a central bank to venture into some 

waters that it just has no business going. Is that your opinion? 

Dr. PLOSSER. Yes, it is. And it is a bit of a slippery slope, because 

it is very tempting on the part of both parties to let that—but then 

it is—again, it is hard to hold the Fed to make it transparent and 

to hold it accountable for the kind of things that you actually want 

them to be focused on. And the same thing for the fiscal authorities, by the way. 

Mr. HUIZENGA. Thank you. Thank you, Mr. Chairman. 

Chairman BARR. The gentleman’s time has expired. And the 

members have requested a brief second round of questions, if the 

witnesses will indulge us with their considerable expertise. This 

has been a lively discussion. We appreciate your expertise so much 

that members would like to ask you a second round of questions. 

So I will start that second round by yielding myself an additional 

5 minutes. Picking up where Chairman Huizenga was going right 

there, on the downside risk of blurring the lines of accountability 

for monetary and fiscal policies, Dr. Plosser, let’s talk about the 

legislation that is before you right now. And the Independence from 

Credit Policy Act, which is one of the three bills there, how well 

does that legislation help the Fed avoid that downside risk of blurring the lines of accountability between monetary policy and fiscal 

policy? 

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30 

Dr. PLOSSER. This is a topic I have been talking about actually 

since 2009, was when I first raised this question and asked for a 

new accord. And the problem is that what I see in the legislation 

and what I have advocated in the past has been this idea that, 

look, 13(3) had never been used since the Great Depression. It is 

not something you are going to rely on very frequently. 

But my view is that it shouldn’t be the authority of the Fed to 

lend money for the purchase of Bear Stearns and buy assets, private-sector assets. That belongs to the fiscal authorities. And so I 

actually think that the treasury secretary needs to instruct the Fed 

to carry out such an action. Maybe it was all decided in consultation with the Fed and other regulators about what needed to be 

done. But it needs to instruct the Fed so that this is not—the Fed 

can’t take this on its own. 

Chairman BARR. And, Dr. Plosser, is it an appropriate solution 

to require the swap of Treasuries for mortgage-backed securities? 

Dr. PLOSSER. The Fed is the fiscal agent in many cases for the 

government, in most cases it is, and so it is appropriate for the 

Treasury to instruct the Fed to do something on behalf of the government as their fiscal agent, but then to keep the Fed whole, you 

would engage in a swap of those private-sector securities for Treasuries, and then the Fed is back to where it was before, and it is 

not responsible for that. It is in the Treasury that makes it— 

Chairman BARR. So the fiscal responsibilities remain with Treasury. 

Dr. PLOSSER. Exactly. 

Chairman BARR. The agency responsibilities, the monetary policy 

responsibilities remain at the Fed. Let me also allow you to respond to the typical criticism of Fed reform initiatives, and that is 

that when Congress intervenes in this way and proposes reform, 

that, in fact, Congress is compromising the independence of the 

Fed. Could you elaborate on your argument that no, in fact, this 

legislation preserves the independence of the Fed? 

Dr. PLOSSER. So that is exactly right. I think it helps the Fed, 

because what it does is when Congress, for example, comes to the 

Fed and say, we want you to pay for part of this transportation bill 

or infrastructure bill or what have you, would you buy some municipal bonds or something from—to help bail them out, the Fed has 

a basis for saying no, that is not in our purview. 

Chairman BARR. OK, so now, Dr. Bernstein and Dr. Levy had an 

exchange there. Dr. Bernstein made the point that productivity levels are not the result of unconventional Fed policy or discretionary 

Fed policy. Dr. Levy—perhaps productivity—low productivity is a 

function of a lot of things other than monetary policy. I think there 

is an agreement on the panel that that is the case. 

But could you address the issue of what unconventional monetary policy does to impede maximum economic outcomes? 

Dr. LEVY. OK, so unconventional monetary policies during emergencies don’t impede. During normal periods, they distort financial 

markets by keeping rates too low, having excess liquidity in the 

economy, and this leads to a misallocation of resources. 

But I would say as long as inflation stays low, it doesn’t have a 

significant depressing impact on productivity. Productivity is a 

function of a whole host of other issues. I would say there is the 

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31 

long-run risk of being excessively easy. It catches up with you, and 

it could lead to undesired increases in inflation and interest rates. 

Chairman BARR. And so what I have heard here today from the 

witnesses is that the principal contribution that monetary policy 

can make—however limited that contribution can be—is primarily 

that it can provide—it transmits price signals, clear price signals 

to actors in the private economy, which in turn can provide a level 

of certainty for households, investors, and small businesses. 

Dr. LEVY. Yes. 

Chairman BARR. And I think that is what we are trying to get 

at with the strategy-based monetary policy. My time is expired on 

my second round. And I would like to now recognize the Ranking 

Member for an additional 5 minutes. 

Ms. MOORE. Thank you so much. Let me just open up by asking 

Dr. Levin a question. You are a former staffer at the Federal Reserve, so I think what you might have to tell us is very instructive. 

You attached to your written testimony a paper that you coauthored with several other people stressing the importance of diversity at the Federal Reserve. What was the essence of that, just very 

briefly? Why do you think that that is important? And what were 

you talking about in terms of diversity? 

Dr. LEVIN. OK, well, there are a couple of dimensions of this that 

are important. Jordan Haedtler, who is one of the coauthors, is actually sitting here. Valerie Wilson, from Economic Policy Institute, 

was the other coauthor. The three of us wrote this together. 

But let me just give you a couple of kind of key points. First, as 

I said in my statement, the Fed is America’s central bank. It serves 

the whole public. Its decisions affect everyone. So there is a kind 

of chain of accountability here. The Federal Reserve reports to Congress. But the Federal Reserve serves the public. 

And so it is critical for the Congress to ensure that the Federal 

Reserve is serving the public as well as possible. A key part of our 

report is that the regional Federal Reserve banks are legally private institutions. Now, it was set up that way for good reasons in 

1913, but you should understand that as of today, the Federal Reserve is the only major central bank in the entire world, the only 

one, that has such a significant private component to it. And so I 

think it is important for Congress over time to revisit this issue. 

One possibility is to appoint a centennial commission, some people have raised this idea, and that could be, I think, a bipartisan 

initiative to say that we need to reconsider this. Some of the rationale for what the Fed did 100 years ago, it was banker to the banks. 

That was its primary role. 

Ms. MOORE. OK. Thank you. That is very helpful. 

Dr. LEVIN. Yes, OK. 

Ms. MOORE. Dr. Bernstein, outgoing Fed Chair Yellen has shared 

with us many times that she thinks—she believes that inequality 

is very dangerous. And so as I have thought about the testimony 

here today and an assessment and evaluation of what the Fed did 

do or didn’t do, one of the things I know is our dual mandate to 

look out for those who are unemployed. 

Can you share with us whether or not you think some of these 

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32 

erence to that other dual mandate? And what is your view on inequality and the danger to our role? 

Dr. BERNSTEIN. Well, I am glad you raised that, because I think 

that those kinds of concerns have been really conspicuously absent 

from this discussion so far. And it is a glaring absence. 

So much of the discussion has focused on credit markets, on how 

the financial sector is doing, on messages and signals and certainty 

to the financial markets. That is all critically important, no question. But, in fact, if you look at the sector the economy that has 

really been doing great in recent years, it is precisely that side. The 

share of national income going to profitability, the equity prices of 

the financial markets have been extremely strong. 

Where we have problems—even at 4.1 percent unemployment— 

is pockets of weakness in labor demand, pockets of severe weakness in income growth. And it is that reason that the Federal Reserve has engaged in lots of the initiatives that have taken a hit 

here today from my colleagues, because interest rates are stuck at 

zero, the Federal funds rate has been stuck at zero, and so they 

needed to engage in other techniques in order to try to further 

stimulate the economy to reach those who have been left behind. 

If you listen to Janet Yellen talking about either this problem, 

the employment side of the mandate, or inequality, you will very 

clearly hear those concerns. And so we have to acknowledge that 

there are a lot of people who are missing in this room today from 

this discussion, and they are the people who are helped most by 

the employment side of the dual mandate. It has been a critical 

omission, I think, for much of our discussion. 

Ms. MOORE. Anybody dying to say anything up there? 

Dr. LEVIN. Well, I just want to reinforce what you said about diversity. It is critical for the members of the FOMC and the Federal 

Reserve Board, but all the regional Fed presidents, to have geographical diversity. That is why it was created as a regional system. That is really important. They need professional diversity, 

background, different educational backgrounds. It is great to have 

a Congressman— 

Ms. MOORE. You need any black people on the— 

Dr. LEVIN. Absolutely. Of course. 

Ms. MOORE. OK, OK. My time is expired. 

Chairman BARR. The gentlelady’s time has expired. The Chair 

recognizes the gentleman from Texas, Mr. Williams. 

Mr. WILLIAMS. Thank you, Mr. Chairman and Mr. Levin. The 

FOMC proposal before this body today seeks to increase transparency and make clear the way that the FOMC makes its decision. In your testimony, you discussed the fact that the Fed’s monetary policy strategy is not well understood. 

So in what ways does the current communication policy keep the 

boss or Congress, as you say in your testimony, well informed 

about the FOMC strategy? 

Dr. LEVIN. OK, so, first of all, the draft legislation requires that 

the Federal Reserve have a clear strategy. That would already be 

a significant step forward. The legislation requires that the strategy should be—identify a specific policy instrument, which could be 

the Federal funds rate, it could be the repo offer rate. It might be 

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33 

something else over time. OK. It identifies a specific policy tool that 

it is going to use, identify specific indicators. 

Now, as Jared said, and I agree with him on much of this, there 

were times in the past 5 years the unemployment rate was not a 

very sufficient indicator of the labor market. President Trump has 

emphasized that himself, that there are broader measures of unemployment. Jared has emphasized in his writings—we call it U–6— 

you know, that includes involuntary participation and people on 

the sidelines. 

So, again the Federal Reserve needs to have a clear strategy or 

explain to the public how it is responding to these indicators. It 

should be a small number, simple, clear indication. 

Again, I want to come back to the analogy about the patient. A 

child, I have a 9-year-old son, so this is—it hits home for me. When 

the patient is sick and you go to a team of doctors, it is a difficult 

illness. You want a clear strategy, and you want—the doctors have 

to consult with the patient’s family. Everyone understands that. 

And we are talking here—as Ranking Member Moore said, we 

are talking—and Jared said—this affects all Americans, in the 

inner city, it affects small businesses, it affects large corporations, 

it affects people in other countries, too. And so it is really critical 

here that this team of doctors on the FOMC has a clear strategy 

that the public, the Congress, financial markets, small-business 

people, everyone can understand that strategy and the debate 

about it. 

I am totally in favor of second-guessing, by the way. I secondguess the Fed myself. But if you don’t have a clear strategy, then 

you can’t debate about it. And it needs to be a public debate about 

what the Federal Reserve is doing. 

Mr. WILLIAMS. OK, well, let me ask you this. If the Fed takes 

a data-driven approach to monetary policy, as they have said they 

do, does it follow that allowing a clear picture in predicting future 

policy direction will be beneficial to investors and the economy as 

a whole? 

Dr. LEVIN. Yes. And again, during normal times, this may not be 

so complex. There may be periods when the Federal Reserve’s policy rate is more or less normal and more or less stays within a narrow range over a period of time. What we are really talking about 

here with strategy is times when things are not normal. How is the 

Federal Reserve going to respond to that? 

I keep coming back here to contingency planning, because, again, 

this is a good business principle for a nonprofit organization, too, 

to be thinking about, what might go wrong? And how will the Federal Reserve respond to that? I call it stress tests for monetary policy. You are the boss. You should be asking the Federal Reserve, 

if we have a recession next year or 2 years from now or 5 years 

from now, what are the Fed’s plans? How will it respond? Is it 

going to do more QE? Is it going to go to negative interest rates? 

These are critical to the whole American public and to the global 

economy. You are the boss. You have to get clear answers from the 

Federal Reserve on these issues. 

Mr. WILLIAMS. OK, Mr. Chairman, I yield my time back. Thank 

you. 

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34 

Chairman BARR. The gentleman yields back. The Chair recognizes the gentleman from Arkansas, Mr. Hill, for another 5 minutes. 

Mr. HILL. Well, I have enjoyed this discussion. Of course, when 

you are with the deliberative body of second-guessers, we can relate to your comment. We are experts at it. 

But one of the biggest impacts of the last 10 years of Federal Reserve policy is skewing benefits to the carry trade and to stock 

market investors and 401(k) investors and driving down interest 

rates on real estate to, I would assume, non-economic type levels. 

So there has been a lot of beneficiaries. 

And I agree that they really have not reached a lot of the working people, because we have not seen wage growth or productivity 

growth, to Dr. Levy’s comment about aggregate demand has not reacted to this 10 years of extraordinary stimulus, unseen in history. 

I mean, we are—we have never seen lax monetary accommodation 

like we have seen now. 

I want to switch bills for a minute, Mr. Chairman, and talk a bit 

about the emergency lending proposal that is before us. And of 

course, the theme that we had both in the Choice Act and here is 

well-collateralized loans not to insolvent entities at a penalty interest rate and at a short-term duration, but this bill limits that to 

financial institutions, supervised by the Fed, for example. I would 

be curious of the panel’s view. Is that too narrow? Should 13(3) be 

limited only to commercial banking institutions or their holding 

companies, to be specific? 

I would just like a view from all four of you. Dr. Plosser? 

Dr. PLOSSER. I think that is a bit of a difficult question. And I 

do think that if you accept the notion, as the Fed has argued, that 

there are a lot of non-banks, for example, who are involved in financial markets heavily. And so-called shadow banking system, 

how far do you extend this safety net? 

The problem is, I think, is—if it is a safety—the Bagehot’s rule 

for—Walter Bagehot rule for emergency lending was, as you said, 

lend freely at a penalty rate to solvent institutions. So now what 

we really are talking about is, do you want the Fed lending to insolvent institutions? And if so, what is the reason for that? And 

what is the rationale for that? 

That is not what lender of last resort means. So I think we have 

to be careful about how we do structure this. 

Mr. HILL. Well, I would just—the bill before us, though, is—the 

borrower is affirming the borrower is not insolvent. So, I mean, the 

real question I have is, should 13(3) be extended to a non-banking 

entity? 

Dr. PLOSSER. I guess, if I had to—given the way it is structured, 

I would say no. I don’t think it is necessary. 

Mr. HILL. Thank you. Dr. Levin? 

Dr. LEVIN. Well, I just want to reiterate something that Dr. 

Bernstein said, which is most other central banks around the world 

do have broad authority in an emergency of what kinds of actions 

they can take. And it is not just about lender of last resort, and 

it is not just about too-big-to-fail. 

What is the most important thing the central bank does? Is to 

keep a stable unit of account. We call it price stability. That is part 

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35 

of the Fed’s mandate, OK? That is the single critical thing. And in 

a really severe short, like we had in the Great Recession, or even 

going back to the Great Depression, we didn’t have price stability 

in the Great Depression. Prices fell 25–30 percent. 

So it is critical for the central bank to have enough tools so that 

when there is that kind of shock that it can make sure that the 

price level comes back to a stable level. So, again, I think there is 

a case for a centennial commission that would think carefully about 

what can we learn from history, what can we learn from other central banks, what can we learn from what worked and didn’t work 

in the past recession? Frankly, I think the Fed itself needs to do 

more lessons learned and come back to you. You are the boss. And 

help think through—we want to be prepared for the next crisis. 

Mr. HILL. I agree. Let me hear— 

Dr. BERNSTEIN. I can be very brief. I can be very brief. 

Mr. HILL. —from Dr. Bernstein and Dr. Levy. 

Dr. BERNSTEIN. Yes, I think that is too restrictive. And I think 

the Fed needs to be able to lend beyond services—may well need 

to lend beyond financial services in emergency because we just 

don’t know the sector from which the next emergency will hail— 

Mr. HILL. Thank you, Dr. Bernstein. 

Dr. BERNSTEIN. —much as Andy suggested. One quick thing. I 

would encourage you to read what I wrote in my testimony about 

the penalty rate. I actually think the penalty rate in this proposal 

is less well thought through than the one in the Warren-Vitter proposal. 

Mr. HILL. Thank you. Quickly, Dr. Levy? 

Dr. LEVY. No further comment. 

Mr. HILL. OK, thank you very much. I yield back, Mr. Chairman. 

Chairman BARR. Gentleman yields back. Chair recognizes the 

gentleman from Ohio, Mr. Davidson. 

Mr. DAVIDSON. Thank you, Mr. Chairman. Thank you all for taking additional questions. 

As we talk about second-guessing, I guess that is part of the 

whole point of this approval process or validation that Congress 

agrees with what the Fed has done in this emergency lending authority. And, Dr. Levy, I was just curious if you could comment on 

how the market might react to this period. If this becomes law, we 

know that it is sort of a conditional action, so it should be extraordinary. There are a lot of safeguards. It is a very high threshold 

that the Fed would go through to give approval. But once they do, 

how do you feel the market would react in this period before it is 

validated? And then what if Congress does say, no, we are not 

going to give our consent to that? Because it requires positive action. 

The asset would presumably be worth even less. How do you see 

the market reacting to that? 

Dr. LEVY. I can only have two comments in response to your 

question. And one is, what is the source and character of the crisis? 

And I would just note the next crisis is likely to be unlike the prior 

one. 

And the second point I would make is, the markets are going to 

move in response to the crisis. They are not going to wait around 

for the Fed and the Congress to respond. It will, of course, respond 

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36 

to whatever the Fed does, but the markets are going to—they sense 

things. They are going to front run whatever you—they are going 

to be way out in front of you. 

Mr. DAVIDSON. Well, there will probably be indicators of what 

they expect Congress will react to, the new dynamic. 

Dr. LEVY. Well, wait, let me qualify what I just said. The markets would take comfort if they perceived that you had thought 

through logical strategies in response to different types of crises. 

The markets would certainly take comfort in that. And also, I think 

communications about what you are going to do are critically important. 

Mr. DAVIDSON. So I thank you for that. And, Dr. Levin, you commented a little bit about the desired goal of something clear in advance. But here it is retroactive. It is second-guessing something 

that has been done by the Fed. And so, Dr. Plosser, I am curious 

your thoughts, in terms of you are 25 days past, and the country 

can sense Congress isn’t going to take action, isn’t going to validate 

that. Is the timeframe important? Is it 30 days? Is it 6 months? 

Does it have to be paid back within 30 days? How important is this 

to the market function? 

Dr. PLOSSER. So let me start by pointing out that one of the values of doing this is that you set out a process about, if such and 

such happens, this is what we are going to do. These are the steps 

that are going to be followed. That is known in advance, all right? 

So markets will build in to their own assessments—it is like a 

bankruptcy law. A bankruptcy law says if a firm goes insolvent, all 

debt is put into a holding pattern until you can sort through the 

assets and liabilities and figure out who gets paid. That is the law. 

So pricing of those assets in advance understands that step. 

Well, this is kind of the same idea. Here is what is going to happen, so you—by laying it out in advance what the rules of the game 

are going to be, markets will price that, in effect, well before the 

event actually happens. So that is going to make it less stressful 

than it might otherwise be if this came as a surprise of some kind. 

The second step, as you were getting to, well, how long should 

this holding period be on assets, until Congress decides? Well, 

again, I think that knowing this process in advance—and there is 

a lot in the bill about how Congress is expected to behave and how 

quickly they are supposed to make a decision on this, I think all 

of that is going to be filtered in, and the markets will make an assessment whether they think this is a good case for a rescue or not. 

And it is going to make the hurdle rate for the secretary of treasury to back the Fed in doing this. If he doesn’t think he can—if it 

is not a good case and he is not going to be able to make the case 

to Congress, then it might not happen. 

But these rescues shouldn’t be made easy. They are not—you 

don’t want to encourage them and make them so easy that it just 

happens. So I think, yes, it is not perfect, but I think as long as 

you lay out the process, things will work as we think they should. 

That is all. 

Mr. DAVIDSON. It is a good principle. Thank you, and my time 

is expired. 

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Chairman BARR. Time is expired. The Chair now recognized for 

our final 5 minutes of questioning the gentleman from Indiana, Mr. 

Hollingsworth. 

Mr. HOLLINGSWORTH. Best for last here. You know, one of the 

things that fascinates me about economics generally, something 

you guys know far more about than I do, is just kind of its reflexive 

nature. And one of the things I really worry about, right—it has 

been a long time since I took Econ 101, but permanent income hypothesis, right, and the idea that we are working down somebody’s 

curve in their preferences for consumption today versus saving for 

consumption later. But with the extended period of time with 

which we have undertaken these extraordinary measures, whether 

instead of working down that curve, we are bending that curve and 

permanently distorting their impression and their tradeoffs between present and future, and it will be difficult for us to either 

work that curve again or bend that curve back, such that monetary 

policy in the future might have meaningful impacts in the short 

run, at least. 

And I wonder kind of what your, Dr. Levy and Dr. Plosser, view 

on that is and whether we are, indeed, beginning to shape, permanently alter or misshape expectations for the future? 

Dr. LEVY. I think yours is a very valuable observation. And I 

would just bring out something that I am very concerned about, 

and that is the Fed’s policies—and it has had the Federal funds 

rate below inflation now ever since 2008—and its massive balance 

sheet, people who have come to believe that this is normal. And 

when I say people: Households, businesses, savers, and financial 

markets. 

And that potentially raises the costs of exiting and going back to 

normal. I would say so far the Fed has been lucky. And I would 

argue also that the Fed has been able to be leisurely in its exit because its policies to stimulate aggregate demand haven’t worked. 

So I am very concerned about your point that this—we perceive 

current policy as normal. It is absolutely not. 

Mr. HOLLINGSWORTH. Right. Dr. Plosser? 

Dr. PLOSSER. So I agree with what Dr. Levy just said. I think the 

other thing is to recognize that during this period there has been 

this huge conflict in public policy. There is the Fed trying to cut 

interest rates to zero to encourage people to spend, spend, spend 

today, don’t save, don’t save, spend. And then there is the pressure 

on banks to not lend, not lend, not lend, unless you are really certain. 

So we are trying to—we are tugging at each other in ways that 

are—it is confusing, I think, to the general public in terms of, how 

are they supposed to respond to all this? 

Mr. HOLLINGSWORTH. Right, right. 

Dr. PLOSSER. And you are telling the banks not to lend and build 

capital, and telling the public, no, no, no, borrow all the money you 

can. And I think that that tension is reflected in part—what you 

are saying is, are changing people’s behavior about their preferences for borrowing—spending today versus spending tomorrow? 

And since we wiped out a whole bunch of wealth in the housing 

crisis, now what do households typically want to do? They don’t 

want to spend. They need to rebuild their wealth. 

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38 

And so there are all these sort of conflicts that are going on that 

have, I think, been not very helpful at the bottom line. 

Mr. HOLLINGSWORTH. And, Dr. Levy, something you have talked 

about a few times and I just wanted to bring back that point—look, 

we talk about the philosophy behind whether the Fed should be involved in such activities that add to such huge amounts to the 

Treasury, but also how those seemingly large amounts might pale 

in comparison to the potential losses, should interest rates begin to 

rise and accelerate steadily. And so an old adage someone once told 

me was be careful picking up pennies in front of a freight train. 

Even if you get it right a dozen times in a row, you don’t want to 

be wrong once. And I think that your point about that several 

times is ringing true in my mind. 

And, Dr. Levin, something I wanted to bring up and just talk a 

little bit about. You have pushed hard for transparency and pushed 

hard for a cogent strategy. And one of the things that is challenging about this, right, is knowing what success looks like, because everybody has a different vision of what is success. What is 

full employment, right? 4.1 percent seems like full employment, but 

you look at U–6, you look at wage growth, and maybe we aren’t 

really at full employment. All of these things. 

So to me, that harkens back to the need for a cogent strategy and 

transparency about how we will work these variables into something, right, whether that is a Taylor rule, whether it is some discretion around the Taylor rule, just some understanding of these 

are the things we consider important and these things moving in 

these directions will give us indications, but not a clearly defined 

‘‘end goal,’’ if you will, since we will never be able to measure what 

success really looks like. 

Is that something that you would endorse theoretically? 

Dr. LEVIN. Yes, and I would just underscore something I think 

Dr. Plosser said earlier. The Fed’s job is not fine-tuning the last 

tenth of a point on the unemployment rate or the inflation rate. 

But it has a crucial job. And I think part of the balancing you are 

talking about is the risk management. 

Again, like a team of doctors, to explain and say we have a 

bunch of diagnostic tests, but they are a little bit hard to read here. 

This is an unusual case. And so we are going to be keeping a close 

eye on the patient. And if this indicator goes up any further, we 

are going to have to take some action. Those are the sort of clear 

strategies I think your draft legislation is exactly looking for the 

Fed to start doing. 

Mr. HOLLINGSWORTH. Perfect. Thank you, Mr. Chairman. And I 

yield back. 

Chairman BARR. Thank you. The Chair yields back. And I would 

like to thank all of our witnesses for your illuminating testimony 

here today. And, Dr. Levin, appropriate that we leave the hearing 

with another reference to the excellent analogy of the patient and 

the family. And for laying the foundation for a strategy-based monetary policy that can help lift our economy. 

With that, without objection, all members will have 5 legislative 

days within which to submit additional written questions for the 

witnesses to the Chair, which will be forwarded to the witness for 

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their response. And I ask our witnesses to please respond as 

promptly as you are able. 

This hearing is now adjourned. 

[Whereupon, at 4:27 p.m., the subcommittee was adjourned.] 

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(41) 

A P P E N D I X 

November 7, 2017 

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Center on 

Budget 

and Policy Priorities 

November 7, 2017 

820 First Street NE, Suite 510 

Washington, DC 20002 

Tel: 202-408~1080 

Fax: 202-408-1056 

center@cbpp.org 

www.cbpp.org 

Testimony of Jared Bernstein, Senior Fellow, 

Before the House Committee on Financial Services: 

Subcommittee on Monetary Policy and Trade 

Chairman Barr, ranking member Moore and members of the Committee, thank you for holding 

this hearing on the transparency, bond purchases, and lending policy of the Federal Reserve in 

pcrjods of economic stress. As was the case when I testified before this committee a few months 

ago, I return with a similar message: the independence of the central bank is an essential ingredient 

to its timely, efficient, and effective functioning. Of course, that independence exists within the legal 

context set forth by Congress, and, especially as the economy and markets evolv-e, it is not only 

appropriate, but essential, for this committee to continuously revisit this context. But in doing so, 

maintaining the central bank's independence and efficient functionality n1ust always be an elevated 

consideration. 

The bills under discussion today seek to alter the context within which the Fed operates by 

constraining some aspect of its operations, specifically emergency lending and bond purchases~ and 

by adding reporting/ transparency requirements. I find some of tbe ideas to be worthy of 

consideration, but some are too rest11ctive, threaten the Fed's independence, and add unnecessary 

and potentially damaging process requirements that could potentially do more harm than good to 

the US and even the global economy. 

Economic policy always invokes tradeoffs, in this case between the central bank's independence 

and ability to act quickly in emergencies on the one side, and its accountability and contributions to 

potential moral hazards on the other. Getting the balance right is more art than science, but a good 

place to start weighing the tradeoffs is to briefly consider recent Fed perfomunce. 

What is Congress Trying to Fix with these Proposals? 

The American political system exists in a difficult moment. The word Hdysfunction" i5 often heard 

in description of our current situation and I suspect members of this committee would at least 

partially agree with that characterization. Members would also agree that partisanship is at a very 

high level and creates a tall barrier to working together to enact the nation's business. 

Amidst these challenging times, the Federal Reserve is one institution that has been highly 

effective in carrying out its mission. 1bough the Fed failed to identify the housing bubble or forecast 

the crisis when the bubble burst, it quickly moved into emergency mode. The bank deployed its 
43 

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That said, some of the Fed's actions dudng the recession, particularly its invocation of the rarely 

used section 13(3) in its charter (the part that allows the Fed to engage in emergency lending), raised 

legitimate concerns about the creation of moral hazard. Also, even if we agree that the Fed 

performed well in the last cdsis and recovery, we cannot know how future Feds would respond. I 

turn to these concerns next. 

Proposal: "Congressional Accountability for Emergency Lending Programs 

Act" 

The motivation for this proposal appears in large part to be to reduce the moral hazard invoked 

when the Fed provides emergency liquidity to illiquid financial institutions ("moral hazard" occurs 

when an economic entity-a person or an institution-is protected against a dsk such that it has an 

incentive to ignore the consequences of its risky actions). The proposal intends not to eliminate the 

Fed's lending authority, but to significantly raise the procedural bar to its implementation. Though I 

recognize the motivation for the proposal, I see two major drawbacks. First, since the crisis, 

Congress legislated the Dodd-Frank financial reforms, key sections of which were designed 

specifically to reduce the need for Fed intervention in this space. Some of these measures remain 

untested (others appear to be working and are keeping the financial system safer than it was), but I 

sec no reason to add new complexities into this system until we give the Dodd-Frank measures a 

chance. Second, and this is a profound concern with the proposal, it takes the authority for 

emergency lending outside of the Fed and requires both chambers of Congress to provide a timely 

(30-day) approval of the Fed's emergency loans. I believe tlus adds unnecessary risk to credit 

markets and the broader economy. 

The proposal increases the minimum number of Fed officials who must authorize an emergency 

lending intervention from five members of the Board of Governors to eight members of the 

FO.I\fC. It introduces numerous new rules regarding the types of secudties the Fed can accept from 

loan recipients, how the Fed determines the sutTiciency of collateral, it specifies how the Fed must 

construct a penalty rate at which to lend from its emergency facilities, and vadous other technical 

requirements. 

Some of these ideas warrant consideration, e.g., raising the minimum member requirement, while 

others may be ill-advised. The penalty rate is specified as the sum of an average of a disconnt rate 

across all Fed banks and the average spread between distressed corporate debt and a yet-to-bedetermined bond index. This is a highly opaque construct that may or may not serve the purpose of 

the penalty rate, which is to charge a premium above market rates to (a) avoid crowding out private 

lending, and (b) penalize lenders that systemically underpriced risk. The prescribed formula could 

return an overly punitive rate that would potentially undennine the Fed's lender of last resort 

function. For example, it is not hard to imagine a cdsis that "blew out" corporate spreads, which, 

according to the proposal, would have to be embedded in the penalty rate. Thus, here again, the 

proposal mistakenly takes decisions outside of the Fed at risk to the nations credit system at a time 

of great stress. Moreover, I am not aware of compelling evidence that the Fed underpriced their 

penalty rate in the recent cdsis, so tlus is another example of 'don't fix what isn't broken.' 

But my main concern about this proposal is the establishment of procedures for Congressional 

approval of emergency credit. This is a sharp departure from the lending authodty established in 

section 13(3) of the Fed's charter, one that undermines both the independence of the institution and 

3 
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significant weaponry against the downturn, including its iirst line of defense-reductions of the 

policy rate and emergency lending-and later, when the policy rate got stuck at its lower bound of 

zero, it turned to alternative forms of monetary stimulus. TI1ese included "forward guidance"-

communicating its "lower-for-longer" plans to market participants-"quantitative easing," and 

"Operation Twist." Respectively, these largely involved the purchasing of longer-term securities, 

including Treasuries and GSE mortgage-backed securities, and extending the maturity of the Fed's 

bond portfolio. 

While some of these actions are behind the motivations for this hearing; my assessment of their 

impact, presented in some detail in my July testimony, is that they were effective in offsetting the 

historically large demand contraction that followed the crisis. Looking at the full spate of monetary 

interventions described above, Blinder and Zandi find that in 2014, real GDP was 5 percent higher 

than it otherwise would have been; the level of payroll employment was 4 million jobs above the 

alternative; the unemployment rate was more than two percentage points lower against a 

counterfactual of no intervention. 

l also cited research that tries to isolate the impact of quantitative easing, including bond 

purchases that would not be pern1issiblc-agency MBS purchases-under some of the legislation 

under discussion today. John Williams argues that "the central tendency of the estimates fof QE] 

indicates that $600 billion of [the] Federal Reserve's asset purchases lowers the yield on ten-year 

Treasury notes by around 15 to 25 basis points. To put that in perspective, that is roughly the same 

size move in longer-term yields one would expect from a cut in the federal funds rate of 3/4 to 1 

percentage point." This too led to faster GDP growth and lower unemployment. As I noted in Julv, 

"\X'illiams reports on research that finds the Fed's LSAP program lowered the unemployment rate 

by one-quarter of a percentage point, which in today's labor market amounts to 400,000 jobs. 

Blinder and Zandi, using a macro-model to score QE against a baseline w~th no such intervention, 

estimate that from 2009-14, QE lowered the 10-year Treasury rate by 1 percentage point and raised 

the level of real GDP by 1.5 percent." Other research T cited found that the Fed's MBS purchases 

lowered mortgage rates by roughly 100 to 150 basis points, which the researchers (Hancock and 

Passmore) attributed to both the announcement of a "strong and credible government backing for 

mortgage markets" and the actual purchases themselves. 

Post-recession, the Fed continued to promote the recovery and the unemployment fell to what is 

now the lowest jobless rate in 17 years. At least until recently, the central bank has been admirably 

data-driven (some analysts, including myself, have questioned recent rate hikes given low and 

decelerating core prices and non-accelerating wage growth); Chair Yellen, in particular, has carefully 

and extensively articulated the bank's thinking and their plans. TI1e job market is solid, with average 

job gains of 190,000 per month over the past two years. Financial markets are particularly strong, 

boosted by strong corporate earnings, and perhaps expectations regarding upper-end tax cuts. Of 

course, all is far from perfect: the Fed has consistently undershot its 2 percent inflation target, and 

wage growth is slower than many analysts would expect at 4.1 percent unemployment. Slow 

productivity growth is another serious shortcoming of the current expansion, but economists have 

little understanding of that phenomenon, and I'm not aware of a credible argument that links this 

result of any central bank policies. 

In other words, if I were looking around \Y/ashington for an instimtion that fits the adage "If it 

ain't broke, don't fix it," my first stop would be the Federal Reserve, and frankly, I'm not sure 

where, if anywhere, I'd go next. 

2 
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its role as "lender of last resort." \V'ith this change, the 535 members of the Congress all become 

lenders of last resort, a possibility I strongly urge this committee to avoid. 

If Congress fails to approve an emergency lending program within the 30 days, the borrower, 

who, by definition, is facing a balance-sheet crisis, must pay the loan back to the Fed. Moreover, 

members of Congress and their staffs must quickly engage in highly technical analysis of whether 

lencling institutions are illiquid or insolvent, and the quality of their collateral. Such analysis, to be 

clear, is standard, ongoing practice at the Fed, but by insisting Congress engage in it as well, the 

proposal introduces the possibility of politicizing the analysis and, if Congress fails to act in a timely 

manner, triggering significant market disruptions. Regarding this last point, consider also that there 

is a strong likelihood these newly required evaluations would be occurring in the midst of a 

pervasive economic shock, if not a recession, meaning Congress would have many other difficult 

matters requiring their attention. 

To be clear, I do think the bar should be high for approval of emergency lending, but my bottom 

line is clearing that bar should be the purview of the Fed, not the Congress. Thus, should the 

Committee consider raising the intemal bar (i.e., internal to the Fed), while this should be done 

carefully with great attention to potential unintended consequences, it is consistent with prudent 

Congressional regulation. Conversely, raising the extemalbar by requiring Congressional approval 

goes beyond that benchmark. 

Turing to my view that provisions of Dodd-Frank potentially obviate the proposal, consider 

recent writings on this point by Fed chair during the financial crisis, Ben Bernanke. He notes that 

(my bold): 

The Fed intervened in the cases of Bear and .AIC; with great reluctance, doing so only 

because no legal mechanism existed to safely wind down a systemic firm on the brink of 

failure. A key clement of the Dodd-Frank financial refonn bill ... was to provide just such a 

mechanism-the so-called orderly liquidation authority, which gives the Federal Deposit 

Insurance Corporation and the Fed the necessary powers to put a failing firm into 

receivership without creating financial chaos ... With the creation of the liquidation authority, 

the ability of the Fed to make loans to individual troubled firms like Bear and AIG was no 

longer needed and, appropriately, was eliminated. As Fed chairman, I was delighted to 

see my institution taken out of the business of bailing out failing behemoths. 

In addition, Dodd-Frank created a vice-chair for financial supervision (currently held by Randal 

Quarles). It added restriction to the Fed's 13(3) authority by requiring: (1) the Treasury Secretary to 

approve any lending; (2) loans to be open to a broad class of borrowers and not to any one 

individual borrower; (3) the names of borrowers to be disclosed to Congress within a week; and (4) 

stricter standards for loan collateral. Dodd-Frank required the U.S. Government Accountability 

Office (CAO) to do a one-time audit of the Fed's numerous emergency lending facilities that were 

established during crisis, leading to seven recommendations to the Fed, "to strengthen policies for 

mana(.;ing noncompetitive vendor selections, conflicts of interest, risks rc:latcd to emergency lending, 

and documentation of emergency program decisions" which the Fed agreed were worthy of 

implementation (the committee would be well advised to follow up on their progress). Dodd-Frank, 

along with recent international accords under Basel III, have increased what many financial analysts 

consider the first line of defense against illiquidity /insolvency crises: capital requirements that 

disallow excessive leverage. 

4 
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The best way to avoid emergency lending by the Fed is to avoid credit avoid bubbles, systemically 

underpriced risk, and the crises that follow these financial pathologies. And the way to achieve that 

is through market oversight and regulation. Of course, even with robust oversight, crises can occur, 

but T'd urge the committee not to involve Congress in the granular analysis and approval of 

emergency lending, but to monitor the effectiveness of regulatory measures currently in place, albeit 

as yet untested. 

In reviewing a proposal much like this one, here's how Bernanke described his concerns, similar 

to the ones I just raised: "[1lheir approach is roughly equivalent to shutting down the fire 

department to encourage fire safety ... Rather than eliminating the fire department, it's better to 

toughen the fire code." President Trump's nominee for Fed chair, Jerome Powell, recently made a 

similar point: "Further restricting or eliminating the Fed's emergency lending authority "rill not 

prevent future crises, but it 'W-ill hinder the Fed's ability to limit the harm from those crises for 

families and businesses." 

In this regard, it is of great concern that some members of Congress want to get rid or de fang 

Dodd-Frank. While such a complex law certainly requires monitoring and improving, broad 

deregulation of financial markets is completely contraindicated in any case. To do so while also 

adding the members of Congress to the list of lenders of last resort would be an extremely reckless 

act of economic policy. 

Proposal: "Independence from Credit Policy Act" 

The main purpose of tlus proposal appears to be to restrict the Fed's debt purchases to Treasury 

bonds. Thus, had this proposal been in place in the financial crisis, the Fed wonld not have been 

able to purchase agency MBS. Tlus would have been a serious mistake that would likely have 

prolonged the downturn, which was, of course, triggered by the bursting of honsing bubble that 

ultimately shut down the flow of credit to the housing sector, a key secror of the economy. 

In fact, John Williams of the San Francisco Fed has argued that the MBS purchases were the 

"most effecti\'e" part of the Fed's asset purchase programs and that they "ended up having kind of 

the bigger bang for the buck than the Treasury purchases." Blinder and Zandi's research, cited 

abr\\'c, underscores these findings: "within a short time," the MBS purchases by the Fed meant that 

"homebuycrs "\\~th good jobs and high credit scores conld obtain mortgages at record low rates, 

which helped end the housing crash." 

Economist Josh Bivens, in recent testimony before the Financial Services Committee, 

underscored a broader theme as to why this proposal would be misguided: 

The key insight behind recognizing that QE needed to go beyond simple Treasury 

purchases to be most effective is simply that there is not just one "interest rate" in the 

economy. Instead, there arc multiple interest rates, and even multiple long-term interest 

rates. And expansionary monetary policy should aim to reduce those long-term interest rates 

most relevant to households' consumption and fitms' in\'estment decisions -and these arc 

not the Treasury rates. Putting downward pressure on Treasury rates should resnlt in these 

other rates coming down as well, but there are times when the risk premium to assets that 

aren't Treasuries rises substantially (say in the aftermath of the Great Recession and the 

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related financial crisis), and simply pulling down only Treasury rates would not be the most 

effective way to conduct monetary policy. 

In the spirit of Bivens' insight, I would encourage the committee to consider the following. 

Uniguely among central banks, the US Fed is, with minor exceptions, restricted to purchasing bonds 

solely from the US Treasury and the GSE's. In this sense, we were ''lucky" that cause of the 

recession was the bursting of the housing bubble, as a channel existed by which the Fed could 

prevent the excessive tightening of credit in that sector. 

As I noted the last time I testified on this topic, the banks of England, Japan, Canada, and Europe 

all have few restrictions on the types of assets they can purchase (though in some cases they must 

seek permission from regulators to go into, for example, eguity markets). This creates flexibility for 

their central banks to bring the water to the specific source of the fire, based on which sector 

experiences a credit crisis. Because such flexibility would be a large change in the US case, my 

suggestion here is that the committee may want to study the practices of these other banks and 

consider their results in the traditionally more constricted US context. 

Bivens' comment correctly suggests that in today's interconnected, global capital markets, we do 

not know from which sector the next credit crunch will emanate. Thus, tlus may a particularly 

imprudent time to narrow the space of the Fed's sectoral interventions. 'lllis observation is also 

worth considering in the context of the rule in the emergency lending proposal that loans should 

only be made to firms providing financial services. That rule represents a very significant reduction 

of the scope envisioned in 13(3) of the Fed's existing charter, and it may also be too restrictive. 

i\dditionally, I urge the committee to consider adding one other type of allowable debt to the 

Fed's portfolio: municipal debt. Though this would rcguire, I believe (others question this assertion), 

a change in the law govertling allowable Fed purchases, this would be a safe way to off.set recessions 

at localized levels while stimulating potentially productive building and the creation of good-guality 

jobs (the Fed is allowed to purchase muni debt, but only up to maturities of six months; this would 

have to be significantly extended for this idea to be operational). 

Proposal: "Monetary Policy Transparency and Accountability Act of 2017" 

This proposal introduces the following language: "The [FOMCJ shall annually establish exactly 1 

monetary policy strategy, which shall serve as a non-technical public communication of the 

Committee's consensus expectation for the conduct of monetary policy during that calendar year." 

The central theme of my recent testimony to this committee focused on why this was an impractical, 

and even unworkable, idea. However, I should note that the current proposal is less burdensome 

than the one under discussion last summer (the Fed Oversight Reform and Modernization Act), as it 

does not require a specific rule nor outside regulatory approval for changes in bow the Fed employs 

rule-based monetary policy. ln this case, the proposal encourages more of the type of transparency 

and public communications in which the Bernankc and Yellen Fcds are already well engaged, though 

with an emphasis on rule-based strategies. Such communication is, in fact, a clear positive 

development for Fed policy and should be further encouraged. 

J\s regards rule-based interest-rate setting, there is clearly a role for benchmarking FOMC 

decisions against rules like variations on the well-known Taylor Rule. In fact, my recent testimony 

argued that "One of the first guestions a monetary economist might ask in assessing the stance of 

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Fed policy is, "where is the Fed funds rate relative to the Taylor rule?" However, while this might 

well be the first question, it should definitely not be the last." 

There are many reasons for t1exibility. First, there's no consensus as to which version of the 

Taylor Rule, or any other rule, should be the "exactly 1 strategy" noted in the proposal. My 

testimony raised actively debated questions of which int1ation gauge should be used, which 

coefficients are most appropriate, what should be the Fed's target inflation rate (more on this in my 

conclusion), and which output gap or "neutral" interest rate should be used (note that these 

variables are "unobservable"; they must be estimated by analysts and there is no consensus on the 

best way to do so; also, they clearly change over time). The Fed also must use real-time data, and 

they need to have the flexibility to discount data they believe will be significantly revised. 

Moreover, when an economist defends rule-based interest rate setting, he or she tends to show 

how their preferred formula follows the actual part of the Federal Funds Rate (FFR). But no one 

should take solace from such comparisons as they embed the strong assumption that the path of the 

FFR was the optimal one for that period and, an even stronger assnmption, that this path should 

dictate the parameters for the optimal path in a later period. 

The table below, updated from my earlier testimony, shows the broad range of formula-based 

interest rates that would have prevailed in the trough of the Great Recession, and those that would 

prevail now. Note the ranges in both columns: from -0.6 to -6.6 percent in the recession, and from 

1.1 to 4.1 percent now. I would certainly hope no member of this committee would endorse the 

high-end of that range in the current expansion, one that would surely slam the brakes on a healthy 

expansion with very low--even too low-inflation. 

So, to the extent that this proposal leads to the Fed to increase their communication and the 

transparency of their operations, it is worth a close look. But any veering into legislating mle-based 

policy making, with granular oversight from regulators outside the Fed, should be assiduously 

avoided. 

Conclusion 

The sound and reasonable motivation of these proposals is to limit moral hazard and to clarify the 

transparency of the actions of the Fed, one of our most important economic institutions. I've tried 

to highlight the tradeoffs invoked by the proposals, as there is, of course, a delicate balance between 

greater Fed oversight and limits on the one hand, and its political independence and efficient 

function, especially amidst crises, on the other. 

There are, however, at least two areas the proposals do not touch on where I believe the Fed 

could improve its operations, both of which bear on issues raised by the proposals. First, the fact 

that the Fed has undershot their inflation target of 2 percent signals a significant problem, both with 

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49 

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the institution's understanding of the forces driving prices and the effectiveness of their monetary 

policy. My testimony reveals that I am a strong snpporter of the Fed and its actions in recent years, 

and yet it is frustrating to hear governors consistently, and, at least thus far, incorrectly, aver that any 

day now, key variables will start behaving as they predict. Clearly, a rethink is necessary, and many 

analysts, including myself, have called for the Fed to consider changes to how they target inflation. 

These ideas include a higher inflation t.~rgct or target price levels (or levels of other aggregates, like 

nominal GDP or the wage base). Former Fed Chair Ben Bernanke recently introduced an interesting 

hybrid: a temporary price level targeting approach that would kick in only when the funds rate was at 

or near the zero lower bound. 

Next, as noted in my testimony, despite internal warnings, the Fed missed the housing bubble, 

and the ensuing financial crisis and deep recession had severe, lasting consequences for both our 

economy and our politics. Tbis should also be an area where the central bank significandy improves 

its performance. Dodd-Frank reforms, discussed above, should be helpful in this regard, as they 

create greater oversight functions and introduce rules for monitoring leverage, such as "stress tests" 

and higher leverage requirements. But more could be done here, as Baker and Bivens argue in a 

recent brief. They suggest three functions that would improve the Fed's bubble-watch capacity, 

including communicating warnings regarding large asset bubbles in key areas, accompanied by 

warnings that the Fed will take steps to deflate the bubble; deleveraging, which could include higher 

margin requirements; and stepped-up bank supervision, as per Dodd-Frank sorts of requirements. 

But the first step must be for the bank to recognize that they do not have the luxury to maintain a 

view that recognizing and deflating systemic bubbles are outside of their purview, and that their job 

is solely to mop up the damage. 

Allow me to close with a comment not on monetary policy, but on its very important complement 

in weak economies: fiscal policy. As I stressed in my last testimony, the policies of the central bank 

cannot offset downturns, especially deep ones, on their own. They can boost liquidity and lower the 

cost of credit, but fiscal policy is an essential demand-side ingredient if we want households and 

businesses to take advantage ofless expensive and more readily available credit. In this regard, the 

pivot to austerity-fiscal consolidation in downturns or weak recoveries-was a significant 

headwind to the recovery following the Great Recession. Moreover, the debt-increasing tax cuts 

currently under consideration by this Congress are extremely ill-advised in this context Even absent 

recessions-a highly unrealistic assumption, of course-just based on our aging demographics, we 

arc going to need more, not less, revenue in the future. And in the context of the next recession, it 

will be much harder to implement essential fiscal policies if deficits and debt levels are rising. 

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Basic Management Principles 

Principle 

Oversight of 

Strategic Plans 

Prompt Approval 

of Extraordinary 

Expenses 

Designated Scope 

of Responsibilities 

Maintain Accountability, 

Avoid Micromanagement 

Maintain Accountability, 

Avoid Micromanagement 

Maintain Focus 

by 

Extraneous Tasks 

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Is the Fed's Monetary Policy Strate

Well Understood by Financial Marke

Probability 

100~==============================~~======

80 

60 

40 

20 

"Coin Toss" 

FOMC 

Meetin

04-~~~~r-r-~~-,~~~~-r-r~~~~~~,-~~+-

Jun Jul Aug Sep Oct Nov Dec 

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Is the Fed's Recent Policy Path 

Consistent with a Simple Benc;hma

Percent 

2.o rr==================;------------

-- Simple Benchmat·k 

--·Actual Federal l<'unds Rate 

1.5 

1.0 

0.5 

_ _..._'lll!all!lt ____ , 

, ........ 

--

.... 

..,., 

...,.,. 

' ,.,. 

,/"/ 

0.0 

-0.5 

2013 2014 2015 2016 2017 
53 

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Strengthening the Federal Reserve's Effectiveness, Transparency, and Acconntability 

Andrew Levin 

Professor of Economics, Dartmouth College 

Testimony before the Subcommittee on Monetary Policy and Trade 

Committee on Financial Services 

U.S. House of Representatives 

November 7, 2017 

Chairman Barr, Ranking Member Moore, and members of the Subcommittee on Monetary Policy and 

Trade, thank you for inviting me to testifY at this hearing. I will start with some general remarks about the 

Federal Reserve's transparency and accountability, and then I will focus on the rationale for establishing 

simple benchmarks to help clarity the Federal Reserve's monetary policy strategy. 

Operational Independence and Accountability 

The Federal Reserve is America's central bank, and its monetary policy decisions affect every 

American--teenagers entering the job market for the first time, and retired people who are concerned 

about the interest earned on their savings accounts; consumers taking out auto loans to purchase new cars, 

and workers at the factories that manufacture those cars; households making payments on home 

mortgages, and construction workers whose firms are deciding how many new homes to build; small 

businesses whose profit margins may be tight, and families that are struggling to make ends meet. 

Given the Fed's crucial role in affecting our economy, it's essential to ask: To whom is the Federal 

Reserve accountable? Or put more simply, who is the Fed's boss? Indeed, this question is fundamental 

for the issues being considered at this hearing. Unlike the Supreme Court, the Federal Reserve is not a 

separate branch of government. Rather, the Fed is an agency qfthe government. Moreover, while the 

Fed's chair and the other members of the Federal Reserve Board are nominated by the President and 

confirmed by the Senate, the Federal Reserve is not like the Treasury Department or other cabinet offices: 

Federal Reserve officials do not report to the President, nor does the Fed operate under his direction. 

So, let me raise the question again: Who is the Fed's boss? And of course, the answer is: Congress. In 

fact, that answer comes directly from the U.S. constitution, which states that Congress has responsibility 

for regulating the value of money, and from the Federal Reserve Act, whereby Congress has delegated 

that responsibility to the Federal Reserve. Thus, the Fed reports directly to Congress, not to the President 

or anyone else. 

Now, I've intentionally used the term "boss" because I think we can draw on some basic management 

principles to shed light on the issues being considered here today. In particular, how should a manager 

delegate authority to an employee in order to maximize that employee's effectiveness and aecountahility? 

Turning to Exhibit# l, here are three common-sense management principles that are followed by every 

well-run business or non-profit organization and that are highly relevant for the draft legislation being 

considered by your subcommittee: 

(1) The boss stays well iiJformed about the employee "s strategy. In many cases, such consultations take 

place in the context of annual reviews, with regular status updates at a quarterly or semiannual frequency. 

These consultations are essential for maintaining accountability while avoiding micromanagement; after 

all, an employee can't be productive if the boss is constantly second-guessing that employee's decisions. 

And as I'll discuss in a moment, this is the basic rationale for requiring the Fed to explain its monetary 

policy strategy in terms of simple policy benchmarks. 
54 

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2 

Exhibit #1: Basic Management Principles 

Principle 

Oversight of 

Strategic Plans 

Prompt Approval 

of Extraordinary Expenses 

Designated Scope 

of Responsibilities 

Maintain Accountability, 

Avoid Micromanagement 

Maintain Accountability, 

Avoid Micromanagement 

Maintain Focus by 

Reassigning Extraneous Tasks 

Relevance (or Dra{t Legislation 

Monetary Policy 

Benchmarks 

Emergency 

Lending 

Credit 

Policy 

(2) Extraordinary budget items require prompt approval. In particular, the employee should have 

authority to incur routine expenses up to a specific cost threshold, whereas the boss has to approve 

extraordinary expenses beyond that threshold. Again, the basic premise is to maintain accountability 

while avoiding interference in nonnal day-to-day operations. And this is essentially the logic for 

preserving the Fed's operational independence but establishing procedures for obtaining prompt 

congressional approval for emergency lending facilities. 

(3) Extraneous tasks should be reassigned elsewhere. Eflective delegation requires a clear delineation of 

the responsibilities of each employee. Thus, if a specific assignment evolves into a task that doesn't lit 

within the employee's job description, then it's generally appropriate for the boss to reassign that task to 

someone else. And this is the basic rationale for the draft legislation on credit policy: The Federal Reserve 

has a legal mandate to set the course of monetary policy, to supervise and regulate financial institutions, 

and to serve as a lender of last resort-the "banker to the banks." In some extraordinary circumstances, 

carrying out that mandate may result in the Fed's acquisition of private assets. However, such assets 

shouldn't stay indefinitely on the Fed's balance sheet but should instead be swapped for U.S. Treasury 

securities, thereby preserving the Fed's operational independence and designated scope of responsibility. 

Monetary Policy Benchmarks 

The transparency of the Federal Reserve's monetary policy framework has improved substantially over 

the past few decades. Some of those improvements were legislated (e.g., semiannual monetary policy 

reports and hearings), some occurred following congressional hearings (e.g., release ofFOMC meeting 

transcripts), and a number of other enhancements were initiated by the Fed itself (e.g., post-meeting 

statements, expedited minutes, and quarterly press conferences). And when the Fed adopted a specific 

numerical inflation target in 2012, it did so in close consultation with members of Congress. Thus, it's 

natural and appropriate to wonder whether there's still room for improving the clarity of the Fed's 

monetary policy strategy? After all, as Fed insiders often note. "{(it ain't broke, don't fix it. " 

One way to address that question is to take a look at the Fed's official communications. For example, at 

the conclusion of its policy meeting last week, the Fed issued a 500-word statement. But nearly all of that 

statement was pure boilerplate, literally repeated word-for-word from the previous statement. There were 

a few brief references to the transitory effects of the hurricanes. But the only substantive changes were 

conveyed in two adjectives: the description of recent economic growth was upgraded from "moderate" 

to "solid", and core inflation was characterized as "sofr." 
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Exhibit #2: Is the Fed's Monetary Policy Strategy Clear to Investors? 

Probability 

A more concrete way of gauging the clarity of the Fed's policy strategy is to look at market participants' 

assessments of the likely path of the target federal funds rate, which is the Fed's primary monetary policy 

tool. Turning to Exhibit #2, you can see that as of last June, investors saw roughly 50-50 odds-just like 

a coin flip--that the Fed would hike interest rates at its December meeting. 1 Those odds bounced 

around a bit over the summer and then suddenly jumped upwards in late September and early October, 

not because of some startling new economic data but simply because Fed officials began clearly signaling 

their intention to hike rates in December. Indeed, investors now sec the prospect of a rate hike as a 

practical certainty even though the December FOMC meeting is still six weeks away. Thus. even though 

Fed officials regularly reiterate that the path of monetary policy is data-dependent and not on a preset 

course, the Fed's policy strategy is not well understood by investors who sift through every tidbit of 

Fed communications, and that strategy is even more opaque to most members of the general public. 

By contrast, simple benchmarks can provide a highly transparent means for the Federal Reserve to 

communicate the key elements of its policy strategy. Of course, the seminal benchmark was created by 

Professor John Taylor of Stanford University and hence is generally referred to as the "Taylor Rule." 

In fact, macroeconomists often refer to this sort of mathematical formula as a "rule" or "interest rate 

reaction function. "However, as Professor Taylor has frequently noted, it would be inadvisable for 

policymakers to adhere mechanically to any simple mathematical formula; rather, such equations 

should be viewed as benchmarks or guidelines for the setting of monetary policy, while recognizing that 

professional expertise and good judgment will always he essential for sound policymaking in practice. 

It should be noted that the use of simple policy benchmarks is not intrinsically "hawkish'' or "dovish" 

in the sense of being tied to a specific view about how the Federal Reserve should fulfill its statutory 

mandate. For example, Taylor ( 1999) analyzed a simple variant of the Taylor Rule that had been used 

in earlier Federal Reserve stall analysis, and Yellen (20 12) referred to that benchmark as the "balanced 

approach rule" in light of its effectiveness in fostering the Fed's dual objectives of maximum employment 

and price stability. 

1 This exhibit shows investors' assessments of the probability that the FOMC will raise the target federal funds rate 

at its December 2017 meeting. These probabilities are computed by the Chicago Mercantile Exchange (CME) and 

posted in real time on its website; see http://"www.cmegroup_comltrading/inlerest-rates/countdown-to-(omc.html. 

The CME options data indicates that investors saw very low odds that the Fed would hike rates prior to December, 

and that expectation proved to be correct. 
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4 

Exhibit #3: Is the Fed's Recent Policy Consistent with a Simple Benchmark? 

Percent 

2l~===~===================~--------~-----------------~---------, 

2013 2014 2015 2016 2017 

Indeed, as shown in Exhibit 3, a variant of the "balanced approach rule" provides a remarkably close 

approximation to the Fed's actual policy path over the past few years. This simple benchmark can be 

expressed as follows: 

i, = O.Si,_1 + O.S[r( + rr, + O.S(rr,- 2) + l.Oygap,] 

where i, is the current lederal funds rate, i,_1 is the average funds rate in the previous quarter, rr, is the 4-

quarter average rate of core PCE inflation, ygap, is CBO's latest estimate of the current output gap, and 

r( is the median projection of the longer-run average real federal funds rate as indicated by the Federal 

Reserve Bank of Philadelphia's survey of professional forecasters. 

This benchmark incorporates two simple adjustments to the formula considered by Taylor ( 1999) and 

Yellen (2012). First, that formula assumed that the longer-run normal value of the real federal funds rate 

had a constant value of2 percent, whereas this benchmark follows Levin (2014) and Blanch flower and 

Levin (2015) in adjusting that value over time based on the evolving views of professional forecasters. 

Second, this benchmark incorporates a moderate degree of interest rate smoothing, consistent with the 

earlier findings of Levin et al. ( 1999, 2003). 

This analysis confirms that simple benchmarks can indeed be helpful in clarifying the Fed's monetary 

policy strategy, thereby contributing to its overall transparency and accountability to Congress as well as 

its effectiveness in serving the public. 

Thank you for your consideration; I will be glad to answer any questions. 
57 

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5 

References 

Blanchflower, D., Levin, A. (20 15). "Labor Market Slack and Monetary Policy." National 

Bureau of Economic Research Working Paper 21094. 

Haedtler, J., Levin, A., Wilson, V. (2016). "Making the Federal Reserve Fully Public: Why and 

How." Economic Policy Institute, Washington, DC. 

Levin, A. (2014). "The Design and Communication of Systematic Monetary Policy Strategies." 

Journal of Economic Dynamics and Control, 49:52-69. 

Levin, A., Wieland, V., Williams, J. (1999). "The Robustness of Simple Monetary Policy Rules 

under Model Uncertainty." In: Taylor, J., cd., Monetary Policy Rules. University of 

Chicago Press. 

Levin, A., Wieland, V., Williams, J. (2003). "Performance of Forecast-Based Monetary Policy 

Rules under Model Uncertainty'' American Economic Review, 93:622-645. 

Levin, A., Taylor, J. (2013). "Falling Behind the Curve: A Positive Analysis of Stop-Start 

Monetary Policies and the Great Inflation." In: M. Bordo and A. Orphanides, eds., The 

Great Inflation: The Rebirth ofModern Central Banking. University of Chicago Press. 

Taylor, J. (1993). "Discretion versus Policy Rules in Practice." Carnegie-Rochester Conference 

Series on Public Policy 39:195-214. 

Taylor, .J. (1999). "A Historical Analysis of Monetary Policy Rules." In: Taylor, J. (Ed.), 

Monetary Policy Rules, Chicago, IL: University of Chicago Press. 

Yellen, J. (2012). "Perspectives on Monetary Policy." Remarks given at the Boston Economic 

Club, June 6. Sec http://www.&deralreserve.gov/newseventslspeechlvellen20 I 20606a.htrn. 
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F lJ II EMPLOYMENT 

'I'd: 2()~- .. HJ8-i08Cl: 1·-a:-.: ~02-4i18-105(J: pathrofulkmp!tJ~'mt:tlt.nrg \\"W\\·.cbpp.urg I offthcchart~bltlg.org 

March 24, 2015 

Labor Market Slack and Monetary Policy1 

By David G. Blanchflower and Andrew T. Levin 

A fundamental cornerstone of modern macroeconomics is that the economy has a balancedgmwth path that is chamct.erized by stable inflation as well &~ st.oacly growth of production 

and employment. In effect, if the economy becomes "overheated" and persistently exceeds 

its ha.lanced-growt.h path, theu the most notable symptom will he an acceleration of nominal 

wages and prices and hence inflation overshooting the central bank's target.. Conversely, a 

persistent shortfall in economic activity and employment. not only h&'l substantial adverse 

effects on households' well-being but. is also associated with downward pressure on wages 

and prices ami hence with inflation falling persistently short. of the central bm1k's target.. 

Thus, ongoing assessments of the contours of the balanced-growth path~~and of significant 

deviations from that path·~ are a crucial element. of the design and communication of monetary 

policy, ("Specially for a central bank with a legal mandate to foster maximum employment 

and price st.ability2 

In gauging movements in labor market. slack over previous business cydes, macroeconomists 

have generally focused on the gap between the conventional unemployment. ra.t.e (that is, the 

incidence of people who are out of work and actively searching for a job) and the "natural 

rate of unemployment" judged to be consistent. with the balanced-growth path. In the wake 

of a severe recession and a sluggish recovery, however, the conventional unemployment gap 

can be a relatively poor or even misleading indicator of labor market slack. In particular, 

a.~sessment.s of the shortfall of employment. from the balanced-growth path should also in1 David G. BlanchAow<~r is the Rruce V. Hauner professor of economics at Dartmouth College) a professor of 

economics at the Uuiversity of Stirling, a rese,arch associate of t.he National Burr:au for Economic Re:'*~arch, 

and a program director and research fellow at the Institute for the Study of Labor (IZA). Andrew T. Levin 

is currently an adviser in the Research Department at the Iuternational I\Jonetary Fund, and he will be 

joining the Dartmouth faculty as a professor of ecouomics in .July 2015. We appreciate many invaluable 

conversations with Laurence Ball, Jnrcd Bernstein, Christopher Erceg, :lv1clinda Pitts, Adam Posen, Lars 

Svensson, and John Taylor. Nonetheless, the views expressed here are solely those of the authors and do 

not necessarily reftcd. the views oft he International ~fonetary Fund or of any other person or institution. 

2

The FOMC's StatcmPnt of Longer-Bml Goals and Policy SJ.rategy (adopted in January 2012 aBd rea.tfirmPrl 

annually since then) describes its mandated objectives of maximum employment and price stability as 

"generally complt>mentaxy." SPe FOJ\1C, "Statement on Longer-Run Goals and Monetary Policy Strategy, 

2014, available at http:/ jwww.federalrescrve.ga~;jmonela'l'YJWlicy. 
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FIGURE 1 

The Recent Evolution of U.S. Nominal Wage Growth 

Percent 

5 

2007 

All Employees 

-------------

2009 2011 2013 2015 

Production & Nonsupervisory Employees 

---- 3-J\fonth Change 

- l2·Montb Change 

2007 2009 2011 2013 2015 

Note: The left panel depicts the growth rate of average hourly earnings i(lr all U.S. private nonfarm 

employees, n.nd the right panel depicts the corresponding growth rate for production and non-supervisory 

employees. Each panel depicts the annualized :l-month change (solid line) and the 12-month change (dashed 

liue). Source: BLS and authors' calculations. 

corporate the extent of hidden v.ncrnployment (that is, people who are not actively searching 

but who would rejoin the labor force if the job market were stronger) and the incidence of 

'itndemmployrnent (that is, people working part-time who want a full-time job). 

In this paper, we begin by examining the evolution of U.S. labor market slack over recent 

years and show that underemployment and hidden unemployment currently account for 

the bulk of the employment gap. Our benchmark a.<>sessmcnt of the current magnitude of 

the shortfall in U.S. employment--including the incidence of underemployment and hidden 

unemployment--is equivalent to about :3.3 million full-time jobs. Moreover, the uncertainty 

surrounding that a.ssessrnent is dearly skewed to the upside, so that the actual shortfall in 

employment might well be twice as large. 

Recent Congressional Budget Office (CBO) analysis indicates that the potential labor force 

i:; currently expanding by about 50,000 to 60,000 individuals per month due to demographic 

factors. Thus, if nonfarm payrolls continue to rise steadily by around 260,000 jobs per 

month (which has been the average pace over the past few quarters), then the employment 

gap might be eliminated toward the end of next year. In contrast, if the economic recovery 

decelerates and payroll growth slows to around 100,000 jobs per month (roughly similar to 

its pace during 2010 and most of 2011), then the employment gap would barely diminish at 

all over corning years. 

Next, using state--level data, we find strong statistical evidence that conventional unemployment, underemployment, and hidden unemployment each exert significant downward 

2 
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pressure on nominal wages. 3 Such results should not be surprising, because employers may 

fill a job vacancy by hiring (a) someone who had been out of work and actively searching for 

a job; (b) someone who had been working part-time, either at the same firm or elsewhere; 

or (c) someone who had just rejoined the labor force and hence wasn't being counted as 

unemployed. 

Recent data on U.S. nominal wage growth is fully consistent with our assessment that labor 

market slack remains substantial. As shown in the left panel of Figure 1, the average hourly 

earnings of all private nonfarm employees decelerated markedly in the wake of the Great 

Recession, and since 2010 nominal wage growth lws remained mired at around 2 percent. 4 

Indeed, the latest 12-mont.h change (from February 2011 through February 2015) was 1.975 

percent.. The right panel of the figure shows the evolution of nominal wages for production 

and nonsupervisory workers, a measure t.hat is less sensitive to movements in the upper tail 

of the wage distribution and hence more informative about broader wage trends. Recent 

readings on this measure point to a significant decline in nominal wage growth over the 

past few quarters: The 12-month chai1ge through February 2015 was just 1.6 percent, down 

nearly a full percentage point from the pace of growth last summer, and the latest 

annualized three-month change was only 0.8 percent. 

Finally, we consider the monetary policy implications of labor market slack using a variant 

of the simple rule that has been extensively studied by Taylor and characterized as the 

"balanced approach rule" by Yellen-" This analysis indicates that the initiation of monetary 

policy tightening would be premature at the prPseut time. Indeed, such a policy move 

would be a serious mistake in light of substantial downside risks to the current economic 

outlook? Rather, liftoff from r.he zero lower hound should be deferred until labor market 

slack has diminished substantially further cmd inflation has moved up significantly closer to 

thP FOI'v!C's 2 percent inflation goal. 

3ln a. sjweclt on .January 15, 2015, Dennis Lockhart (I he president of the Federal Reserve Bank of Atlanta) 

stated that economist-s at his institution have nlso ''advanced the t.hesis that the elevated number of people 

working part-time involuntarily is restraining wage growt.h.n 

4The same pattern is evident for other measure.; of labor compensation such as the employment cost index. 

Indeed, ,1. Robertson and E. Terry ("What·s (Not.) Up with Wage Growth? Ma.crvblog, Federnl Reserve Bank 

of Atla11ta, t"ebruary 17, 2015) a.nalyz(_~d n. range of indicators of nominal wage growth and conduded that 

((none of the charaderistk-specific median growth rates we loob'd at are dose to returning to prereces.sion 

leveh:~. Lower-than-uormal wage growth appears to he a very widespread feature of the labor market since 

the end of the recession.'' 

5 Average hourly earnings of production and uonsupcrvisory workers increased from $20.77 in November 2014 

to $20.80 in 1-<"elwua.ry 2015·-a mea...<;ly raise of just a cents. La.ck of wage growth is also found in other BLS 

wage seriefL Median usual weekly earnings for full-time wage and sala.ry workers grew by 1.9 percent over 

the course of lnst. year and by 1.7 percent in 1.1"' fourth quarter. For all civilian workers, the Employment. 

Cost Index (ECI) grew by 2.2 percent. in both the third and fourth quarters of 2014. 

6This rule was iuit.ially analyzed by ,J. 'litylor, "A Historical Analysis of Monetary Policy Rules, in J. Taylor. 

eel., Monetary Policy Rnlcs (University of Chicago Press, 1999). Its chara.ct.erizalion as a "balanced approach rule was given by J. Yclkn1 '"'Perspectives on 1v1onetary Policy, remarks glven at the Boston Economic 

Club, ,June 6, 2012 (ht.tp:/ /www.fedemb·e,er-ve.gov/ncwsevcnts/speech/yellcn20120606a.hlm.). 

7 According to the US Census Bureau, retail sales declined in three consecutive months: -0.9 perrent in 

December 2014, -0.8 perc:ent. in January 2015, and -0.6 percent in February 2015. 

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Gauging Labor Market Slack 

The Employment Gap 

Our measure of the employment gap is the sum of three specific. components 8 First, the 

unemployment gap is the deviatiou of the conventional unemployment rate~labeled "U3" by 

the Bureau of Labor Statistics (BLS)-from professional forecasters' consensus projections 

of its longer-run normal rate (as reported in semiannual Blue Chip surveys). Second, the 

participation gap is the deviation (in percentage points) of the actual size of the labor force 

from CBO assessments of the potential labor force; this shortfall corresponds to the notion 

of "hidden unemployment" described above. Third, the nndercrnployrnent gap takes the 

BLS measure of people working part-time for economic reasons (expressed as a fraction of 

the potential labor force) as a deviation from its 1994-2007 average and then converts this 

deviation into fnll-time equivalent (FTE) jobsH 

As shown in Figure 2, the U.S. employment gap has narrowed markedly over the past few 

years, along with each of its three components. Nonetheless, it is readily apparent that the 

conventional unc~mployment. rate has not served as an accurate synopsis of the evolution of 

labor market slack. For example, the declining unemployment rate over the course of 2010 

and most of 2011 was not induced by a pickup in job growth but instead reflected the extent 

to which many Americans gave up searching for work and departed from the labor force. In 

effect, the reduction in the unemployment gap was almost fully offset by a.n increase in the 

participation gap, and hence the overall employment gap showed very little improvement 

during that period. 

Even more importantly, it is evident that the U.S. economic recovery remains far from complete in spite of apparently reassuring recent signals from the conventional unemployment 

rate. Indeed, while the unemployment gap ha..s become quite small, the incidence of underemployment remains elevated and the size of the labor force remains well below CBO's 

assessment of its potential. In particular, the employment gap currently stands at. around 

1.9 percent, suggesting that the "true" unemployment ra.tc (including underemployment and 

hidden unemployment) should be viewed as around 7~ percent. Gauged in human terms, the 

current magnitude of the employment. shortfall is equivalent to about 3.3 million full-time 

jobs. 

Of course, the characteristics of the economy's balanced-growth path cannot be directly 

observed, and hence a.ny particular assessment of the deviations from that. path is necessarily subject to considerable uncertainty. In the context. of a typical business cycle, such 

uncertainty might reasonably he judged as symmetric around the benchmark estimate. At. 

the present juncture, however, it seems plausible tha.t prof<:$Sional forecasters and a.na.lysts 

at policy institutions may have become overly pessimistic in gauging the extent to which 

the Great H.ecession caused permammt damage to the U.S. labor market. Consequently, 

8

This measure of the employmE-mt gap wa.s introduced by A. Lcvin1 ((The Design and Communication of 

Systematic Monetary Policy Strategies, Journal of Economic Dynamics and Control (2014 ). 

9The FTE convt~rsiou factor is eornputed using BLS data on the av('Tage weekly hours of iudividuals working 

part-time for economic reasons compawd to the average weekl_y hours of individuals who are working fulltime. 

4 
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FIGURE 2 

Benchmark Assessment of the Employment Gap 

2010 ZOll 2012 2013 2014 2015 

2010 20ll 2012 2013 2014 2015 

Xote: This figure depicts the recent evolution of the U.S. employment gap in proportion t.o the potential 

labor force (t.op panel) and in millions of FTE jobs (bottom panel). In each panel, the dark-shaded area 

denotes the unemployment gap, the medium-shaded area denotes the participation gap, the light-shaded 

area denotes the underemployment gap) and the solid llne denotes the total employment gap; all of these 

series are shown as three-month moving avE'ragcs. Source: BLS1 CBO, and <:uttllors1 calcnlatious. 

5 
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FIGURE 3 

Evolving Assessments of the Unemployment Gap 

Percent 

llr------------------r=~~~~w;----~ Rate 

10 ---- CBO Estimate of Natural Rate 

2008 2009 2010 2011 2012 2013 2014 2015 

Note: The solid line denotes the three-mouth moving average of the U.S. unemployment rate (U3) from 

January 200H to February 2015. The shorhhshed lirw denotes the evolution of CEO's assessments of the 

]oug-run natural n\te. The long-dashed line denotes tlw Blne Chip consensus (that is, the mean projection) 

for the uuemploymtmt rate 5 to 10 ahead, while the upper and lower limits of the shaded area 

represent the projections in t.op and bottom quartiles, respectively. Source: Source: IlLS, Blnc 

Chip Economic and ;;tuthors' calculations. 

the confidence band,; around our current assessment of the employment gap may in fact 

be skewed to the upside; i.e., this assessment may well be an nnder·estimate of the true 

magnitude of labor market slack To examine that possibility, we now consider each of the 

individuaJ components of the employment gap in turn. 

The Unemployment Gap 

CBO regularly produces assessments of the nat mal unemployment rate that would prevail if 

the economy were on its balanced-growth pa.th. 10 More specifically, CBO defines the natural 

rate as the l!>vel of unemployment "arising from all sources except fiuctuations in aggregate 

d<'mand." In the wake of the Great Recession, CBO refined its analysis to gauge the extent 

to which the natural rate has been affected by transitory vs. persistent structural factors. 

Thus, over the past few years CBO has produced estimates of the long-term natural rate, 

which solely reflects the infiucn<:es of lon~er-last.ing structural factors. 11 

10These asseosments are published in CB0 1

s mmual Budget and Economic Outlook document each :January 

or February a_") well a.s in its midyf~ar updates each August. 

11Since 2011 CBO has also produced estimates of the short-term natural rate, which ineorporates the effects of 

transitory structural factors. In 2014, CBO relabekm the "long-term natural rate)) as the "underlying longterm rate of unemployment" and began referring to the "short-term natural rate" a.s simply "the natural 

rate.)' In the immediate aftermath of the Great Recession, the distinction between these two measures was 

quit,e substantia] (with a peak differE-nce of around 0.8 percent.age points). As of 2015, however, the two 

G 
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Surveys of professional forecasters generally do not collect information about their estimates 

of the natural rate of nnemployrnenL However, forecasters routinely make longer-run projections regarding the path to which the economy is expected to converge over time, and 

such projections essentially reflect their assessments of ducradcristics of the balanced-growth 

path, including the growth rate of potential output and the natural rate of unemployment. 

In particular, Blue Chip longer-run surveys (which are condueted semi-annually in March 

and October) report on the consensus and wnge of forecasters' projections of the average 

unemployment rat.e 5 to 10 years ahead. 12 

As shown in Figure 3, the Blue Chip's longer-run consensus outlook in early 2008 was 4.8 

pernmt-··virtually identical to CBO's a.ssessment of the natural unmnploynwnt rate. In effect, 

analysts generally agreed that. the unemployment gap at that juncture was effectively niL 

Shortly thereafter, the actual unemployment rate skyro<:keted upwards, reaching 10 percent 

by late 2009. CBO then raised its assessment of the natural rate by just a notch, whereas 

professional forecasters evidently became much more pessimistic about the prospects for longln.sting damage to the labor market: The Blue Chip longer-run consensus outlook moved up 

to around 6 percent, and the top quartile of projections in that survey reached nearly 7 

Jl("n:ent. By 2012, CBO had come to share much of that pessimism and henee marked up its 

estimate of the long-term natural rate to levels similar to those of the Blue Chip consensus. 

Over the past few years, as the unemployment rate has declined steadily and nominal wage 

inflation has been subdued, professional forecasters have been gradually marking down their 

longer-run unemployment projections. In the Blue Chip longer-run survey published in 

March 2015, the consensus outlook for unemployment was 5.1 percent, while the bottom 

quartile has declined to 4~ percent and the top quartile of projections now stands at 5~ 

percent. Interestingly, that consensus outlook is identical to the midpoint of the central 

tendency of FOJVIC participants' longer-run unemployment rate projections that were released in conjunction with the March 2015 FOMC meeting.- CBO's latest assessment of the 

long-term natural rate (published in late January) was a notch higher at 5.4 percent. 

It seems reasonable to infer that the uncertainty surrounding these assessments is skewed 

to the downside. lndeed, if unemployment declines further over coming quarters while 

wage inflation remains subdued, analysts will presumably make even further downward 

revisions to their assessments of the longer-run normal rate of unemployment. Thus, while 

our benchmark estimate of the unemployment gap is quite small, its true magnitude might 

well be substantially larger-·pcrhaps by as much as thrcc~fourt.hs of a percentage point. 

The Participation Gap 

ln conjunction with its estimates of potential output and the natural unemployment rate, 

CBO produces regular a-ssessments of the historical and projeeted size of the pot.cnl.ial labor 

force, that is, the balanced-growth path for the labor force that would prevail in the absence of 

measures are uow identical; i.e., CBO ha ... s concluded that transitory structural factors are no longer having 

any significant inflnen('e on thf' natural rat<'- of unemployment. 

12 Blm-~ Chip longer-run survey results are reported in the I\{a.rch and October editions of Blue Chip E'conomic 

Indicators, a publication owned by Aspen Publishers. Copyright (c) Aspen Publishers, Inc. All rights 

reserved. 

7 
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FIGURE 4 

Evolving CBO Assessments of the Potential Labor Force 

Millions 

164 Tr.=.=.=_=c=B=o=J=ao=2=o=~~~,--------------------------------, 

162 ---CBO Feb. 2013 

160 

!58 

156 

154 

151 

1~+-----~-----~------r-----~----------~------,-----~ 

2007 2008 2009 2010 20ll 2012 2013 2014 2015 

Note: The solid line denotes the three-month moving average of the U.S. labor force from January 2007 to 

February 2015, and the lhl-shed lines denote the CBO's a ..:;;sessments of the potentlallabor force as of January 

2008 (short-dashed), February 201:1 (medium-dashed), and January 2015 (long-dashed). Each CBO series 

ha' been adjusted to incorporate subsequent revisions to BLS population controls. Source: BLS. CBO. 1md 

authors' calculations. 

aggregate demand Bhocks. In effect, given detailed projections for the size and demographic 

composition of the population (mainly drawing on the work of the Census Bureau), CBO's 

assessments of the potential labor force convey its analysis of how demographic and structural 

faetom :tre likely to influence the evolution of lRhor force participation over time. 

Figure 4 depicts the evolution of CBO's asseosments of the potential labor force. As of 

January 2008, CBO estimated that the actual !:thor force (specifically, about 154 million 

people) was very dose to its potential level; i.e., the participation gap was judged to be 

negligible. Moreover, at that juncture CDO projected that the potential labor force would 

expand at an annual pace of about three-quarters of a percent through 2012 and would then 

decelerate somewhat to an annual pace of about half a percent in subsequent years. 1:

1 

In the wake of the Great Recession, the U.S. labor force actually decreased in size through 

rnid-2011 and then resumed a moderate upward trajectory over the past few years. Nonetheless, from 2009 through 2013, CDO made only modest revisions to its assessments of the 

potential labor force. Most notably, CDO analysis indicated that the labor force had exceeded its potential size by about a full pcre~ntfl.gn point during the lead-up to the financial 

crisis. However, CRO made roughly offsetting adjustments to the projected growth rate of 

the potential labor force, and hence the implications for the magnitude of the participation 

I.> As discussed in C. Erceg and A. Levin (''Labor Force Participation and Monetary Policy in the Wake of 

the Great Recession, .!oumal of Money. C'i'edit and Banking, 2014), CBO's labor force projections in early 

2008 were broadly consistent with the projections that. were published by BLS in November 2007. 

8 
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gap as of 2013 were essentially the same as implied by its January 2008 assessment. 

In contrast, CBO has recently made substantial downward revisions to its assessments of the 

entire post-2008 trajectory for the potential labor force. In particular, CBO now judges that 

dernographie and structural factors account for a larger share of the post-2008 decline in labor 

force participation than indicated by its previous analysis. Moreover, CBO has concluded 

that much of the cyclical decline in labor force participation has become irreversible; i.e., 

CBO now anticipates that only two-thirds of the individuals who departed from the workforce 

in the wake of the Great Recession will rejoin the labor force as the economy continues to 

strengthen. 

Evidently, such judgments have crucial implications for gauging the current magnitude of 

the shortfall in U.S. employment. According to CEO's latest a.o;sessment of the potential 

labor force, the participation gap currently stands at around 0.8 percent (which is the value 

that we used in constructing our benchmark estimate of the employment gap as shown in 

Figure 2). By contrast, CEO's outlook as of february 2013 implies a substantially larger 

participation gap of around 2.6 percent and hence that the employment. gap is nearly t11Jice 

as lm:qe a..<; our benchmark estimate. 

Breaking down the data by gender is also relevant for assessing the extent to which the 

post-2007 decline in U.S. labor force participation might be largely structural or irreversible. 

As shown in the left panel of Figure 5, the participation rate of males age 15 to 54 years 

wa..s drifting downward during the late 1990s, but that trend was arrested and perhaps even 

reversed during the mid-2000s. Thus, there is evidently a substantial degree of uncertainty 

about the current magnitude of the participation gap for this demographic group. If one 

fits a linear trend over the decade ending in 2007, then the actual participation rate is now 

within a percentage point of that trend line-roughly similar to CEO's current assessment 

of the aggregate participation gap. By contrast, if one fits a. lirwa.r trend over the five-year 

period ending in 2007, then the participation gap is around :'1 percentage points, roughly 

consistent with the implications of CEO's assessments several years ago. 

As shown in the right panel of Figure ,5, the participation rate of females age 45 to 54 years 

was essentially flat from 2000 through 2007, a.nd hence there is simply no basis whatsoever 

for attributing its post-2007 decline to structural factors. Rather, it seems evident that this 

decline resulted from the persistent weakness of the job market in the wake of the Great 

Recession. Moreover, the magnitude of that dccline~ahont 2~ percentage points-is virtually 

identical to the drop in labor force participation of a.ll prime-age adults (that is, aged 25 to 

54 years), who comprise the bulk of the U.S. labor force. In effect, this pattern bolsters the 

view that the Great Hecession and its aftermath were largely r<c)sponsible for the post-2007 

decline in the U.S. participation rate, consistent with the conclusions of a nnmber of recent. 

empirical studics14 

14See D. Aaronson, ,J. Davis, and L. Hu, "Explaining the Decline in the U.S. Labor Foree Participation 

Rate, Chicago l'<>d Letter #296, Federal Reserve Bank of Chicago, 2012; J. Sherk, "Not Looking for 

Work Why Labor Force Participation Has Fallen Dnring the Recession, Backgronnder 2722, Heritage 

Foundation Center for Data Analysis, 20!2; W. Van Zondweghe, "Interpreting the Recent Decline in Labor 

Force Participation, Economic Review, Federal Reserve Bank of Kansa..<:; City, 5-341 2012; .J. Hotchkiss and 

F. R.ios-Avila, "Identifying Factors Behind the Decline in the Labor Foree Participation Rate, Business 

9 
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FIGURE 5 

Disaggregated Evidence on Participation Trends 

Males, 45 to 54 Years 

Percent 

90 --~---------------------, 

88 

87 

86 

85 ,....,...,.....,T'~"'T'r'""T'"MT~..,...,=~r-""T'"",..-n, 

1997 1999 20{11 2003 2005 2007 2009 2011 2013 2015 

Females, 45 to 54 Years l'tr('ent 

78r-------------··-··------------------. 

77 

75 

74 

Note: The~ left panel depicls the three-month moving average of the labor force partidpation rate of 

males aged 45 to 54 years (::~olid line), along with linear trends fitted to observations from 1997 to 2007 

(short-dAShed line) and 2003 to 2007 (long-dashed line)_ The right panel depicts the three-month moving 

average of the labor force participation ratP of females aged 45 to 54 years (solirlline), along with its mean 

value from 1997 to 2007 (da,hed line)- Source: IlLS and authors' calculations. 

10 
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FIGURE 6 

The Underemployment Gap 

1995 1997 1999 20{11 2003 20{)5 2007 2009 2011 2013 2015 

Note: This figure depicts the three-month nwving average of the number of people employed part-time for 

economic reasons as a fra.ctlon of total employment (solid liue) and the mean value of that ratio over the 

period from 1994:1 to 2007:12. Source: BLS and authors' calculations. 

Finally, it should be noted that the participation rate of males age 45 to 54 years has 

recently moved up by nearly a full percentage point, rising from 85.3 percent last spring 

to 86.2 percent in the latest BLS employment report. That development may reasonably 

provide some reassurance that the labor market damage from the Great Recession is not 

irreversible and that many other prime-age adults (both male and f~)rnaJe) as well as younger 

adults will decide to rejoin the labor force if the job market continues to strengthen going 

forward. 

The Underemployment Gap 

Gauging the underemployment gap seems relatively straightforward by comparison with the 

challcmges of assessing the unemployment gap and the participation gap. As shown in Figure 

6, the underemployment rate-· that is, the incidence of people working part-time for economic 

reasons (PTER) as a fraction of total employment.·- did not exhibit any trend over the period 

from 1994 through 2007. It seems implausible that the sudden rise in underemployment 

during the Great Recession was caused by demographic or structural factors. And individuals 

who arc underemployed are clearly not. "unemployable" (as some have suggested about the 

long-t.erm unemployed or those who have dropped out of the workforce), since they arc 

already working but simply can't find a full-time job. Indeed, BLS data indicate that the 

average person classified as PTER is working about 23 hours per week. 

and Economic Research 3:257-275, 201:3; and C. Erceg and A. Levin, "Labor Force Participation and 

r..1onetary Policy in the Wake of the Great Recession. :F'or a contrary view, sec Aaronson ct al., ''Labor 

fOrce Participation: Recent Developments and Future Prospects, Brookings Papers on Economic Activity, 

2014. 

11 
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Moreover, it seems unlikely that structural factors are the primary reason why the incidence of underemployment has only declined gradually over the past few years. After all, 

if the economy were on its balanced-growth path and some employers preferred to shift 

their workforce toward a greater number of part-time positions, then those employers would 

need to offer a relatively higher wage to induce workers to take part-time jobs voluntarily··a 

phenomenon that is certainly not evident in the current job market. 

In light of these considerations, it is striking that the underemployment rate has only moved 

about halfway back from its 2009 peak towa:rds its pre-recession level. That pattern might 

well suggest that the overall magnitude of labor market slack may have diminished by a 

similar proportion. In particular, as shown in Figure 2, the employment gap reached a 

peak of about 6 percent in early 2010. Consequently, it may be reasonable to infer that 

the employment gap currently stands at around 3 percent-that is, about a percentage point 

higher than onr benchmark assessment. In effect, the evolution of the underemployment 

gap reinforces the view that the uncertainty surrounding our benchmark assessment of the 

employment gap is skewed to the upside. 

The Wage Curve 

We now move on to examine the extent to which measures of labor market slack over and 

above the unemployment rate impact wages. Vve do so following the approach taken by 

Blanehflower and Oswald, using data from the Merged Outgoing Rotation Group (MOR.G) 

files extracted from the Current Population Survey (CPS) 15 The CPS is collected monthly 

and is used to calculate the unemployment rate and other labor market aggregates published 

monthly in the I3LS in the Employment Situation jobs release. 16 Data are available from 

1990-2012, so with 50 states and the District of Columbia, there are 1,173 observations in 

total. 17 

Table 1 presents resull,s using the log of hourly earnings as the dependent variable, whereas 

Table 2 nses weekly earnings. The results are essentially the same, so our discussion will 

focus on the results shown in Table l. 

15D. Blanchftower and A. Oswald, The Wage Cttrve (Cambridge, MA: MIT Press, 1994). 

16Respondents in the CPS are surveyed for four consecutive months (waves 1-4), and then after a four-month 

break~ arc surveyt.'Ci for another four months (wavci:'! 5-8). The wage questions are only asked in waves 4 and 

8) which are referred to as the "outgoing rotations." Each of the annual f\JORG files has approximatcly 

170,000 wage observations. Data are aggregated to the level of state and year cell including both hourly 

and weekly earnings as well a.s variables on age, gender, race and schooling. This is exact aggregation and 

solves the Moulton problem. So a gender variable in the rnicro data file becomes a variable identi(ying 

the proportion of workers in a state iu a particular year l and so on for the other variables. l\.1apped onto 

the file are data from the BLS on the participation rate ns well a.s the proportion of the employed that. is 

part-time for economic reasons a..s well as the number of the unemployed who have been unemployed for 

less than 26 weeks; 26-52 weeks and more than 52 weeks. 

17Each regression includes the 19 personal control variables described in the previous footnote, a.s wdl as 

a lagged dependent variable that helps mitigate biases of uncertain sign and magnitude that could result 

from aggregation or missing variables. The start date of 1990 is determined by the availability of the labor 

market status variables, whereas the wage data is available for prior years; hence the inclusion of a lagged 

dependent variable does not constrain the length of our sa.mplc. 

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TABLE 1 

U.S. State-Level Panel on Hourly Wages, 1990-2012 

I) Long-Term Unemployment 

Wage,. 1 0.7106 0.6835 0.7101 0.6822 0.7060 

(360 00) (340.65) (350.92) (340.56) (350.53) 

Unemployment Rate, -0.0279 -0.0266 -0.0240 

(60.98) (50.51) (50.32; 

Unemployment Rate,.1 -0.0365 -0.0404 

(90.47) (80.50) 

%Unemployed >26 weeks, -0.0001 0.0002 

(0.45) (10.39) 

% Unemployed >52 weeks, -0.0004 

(10.88) 

Adjusted R2 0.9945 0.9947 0.9945 0.9947 0.9945 

2) Underemployment 

Wage,. 1 0.6825 0.6610 0.6534 0.6607 0.6534 

!330.55) (320.67) (320.04) (320.42) (320.40; 

Unemployment Rate, -0.0256 -0.0064 

(60.46} (10.25) 

Unemployment Rate,. 1 -0.0339 -0.0351 -0.0210 

(80.73) 190.18) (40.27) 

Non-Participation Rate, -0.0956 -0.0830 -0.0906 -0.0823 

(40.94} (40.33; (40.75) (40.33) 

Non-Participation Rate,., -0.0954 

(50.06) 

Underemployment Rate, -0.0213 -0.0149 

(50.87) (40.22; 

Underemployment Rate,. 1 

Adjusted R2 0.9948 0.9947 0.9948 0.9947 0.9948 

Note: All equations include 50 state dummies, 22 year dummies; I 5 schooling variables plus age, gender and two race variables. All variable

logarithms. Each regression uses I, I 73 observations. Each coefficient's !-statistic is shown below in parentheses. Source: BLS and CPS MOR

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TABLE2 

U.S. State-Level Panel on Weekly Wages, 1990-2012 

1) Long-Term Unemployment 

Wage,. 1 0.6499 0.6561 0.6840 0.6560 0.6790 

(340.36) (310.75! (340.21) (310.73) (330.68) 

Unemployment Rate, -0.0441 -0.0443 -0.0405 

(90.17) (70. 70) (70.55) 

Unemployment Rate,. 1 -0.0449 -0.0460 

(90.31) (70.87) 

%Unemployed >26 Weeks, -0.0000 0.0001 

(0.08) (0.34} 

%Unemployed >52 Weeks, -0.0004 

(10.53) 

Adjusted R2 0.9924 0.9924 0.9924 0.9924 0.9924 

2) Underemployment 

Wage,. 1 0.6499 0.6268 0.6!25 0.6128 0.6032 

(330. 74) (290.-17) (280.75} (290.46) (280.75) 

Unemployment Rate, -0.0424 -0.0151 

(80.90) (20.54) 

Unemployment Rate,_, -0.0423 -0.0443 -0.0162 

(80.81) (90.35) (20. 77) 

Non-Participation Rate, -0.1238 -0.1155 -0.1207 -0.1172 

(50.37) (40.99) (50.36) (50.19; 

Non-Pa1ticipation Rate,., -0.1499 

(60.62} 

Underemployment Rate, -0.03!4 -0.0313 

(70.29) (70.48) 

Underemployment Rate,., 

Adjusted R2 0.9926 0.9926 0.9927 0.9929 0.9929 

Note: All equations include 50 state dummies, 22 year dummies; 15 schooling variables plus age, gender and two race variables. All variables 

logarithms. Each regression uses 1,173 observations. Each coefficient's !-statistic is shown below in parentheses. Source: BLS and CPS MOR
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As shown in column 1 of the panel labeled "Long-term unemployment", the lagged dependent. 

variable has a coefficient of 0.7106, consistent with interpreting this regression specification 

as a wage curve rather than as a Phillips curve18 The estimated coefficient of -0.0279 on the 

logarithm of the unemployment rate is negative and statistically significant, with at-statistic 

of around 7. A simple computation indicates that the long-run unemployment elasticity of 

pay is -0.10, implying that a doubling of the unemployment rate is associated with a 10 

percent decline in real wages19 As shown in column 2, these findings are not sensitive to the 

precise timing of the unemployment measure (using the rate in period t- 1 instead of period 

t). Moreover, the results reported here are essentially the same as what Blanchflower and 

Oswald found across many countries and datasets and are also consistent with the conclusions 

reached by Nikjamp and .Poot in a meta-analysis of wage curve estimat~<; 20 

The remaining columns of this panel confirm the findings of Bla.nchflower and Posen 21 In 

particular, these regressions incorporate various measures of long-term unemployment that 

are never statistically significant. Evidently, the pace of wage growth is linked to the overall 

level of unemployment and does not depend on its composition, i.e., the relative incidence 

of long-term vs. short-term unemployment. 

The second panel of the table called "Underemployment," provides some new results. As 

shown in the first two columns, the nonparticipa.tion rate (that is, 100 minus the participation 

rate) has a negative and statistically significant effect on wage growth, consistent with the 

findings of Blanchflower and Posen22 Next, we incorporate the underemployment rate, which 

is defined as the number of workers who say they are working part-time for economic reasons 

as a percentage of total employment shown in Figure 6). '.l'his coefficient estimate is also 

negative and significant, and its inclusion does not influence the statistical significance of 

the other key variables 2 a 

Evidently, wage growth is pushed down by the unemployment rate, the nonparticipation 

rate, and the underemployment rate. Thus, while the unemployment rate may have been 

an adequate indicator of slack prior to the onset of the Great Recession, all of these forms 

18D. Card, "The Wage Curve: A H.eview, Journal of Ec..onornic Literntv ..r-e 33:785-99. 

19Speeifically, this elastidty is computed as -0.0279/(1- 0.7106) = -0.0964. 

20Blan('hflower and Oswald1 The Wage Curve; D. Blanchflowl."r and A. Oswald, ><The wage curve reloaded. 

NBER Working Paper #11338, 2005; P. Nijkmnp and J. Poot, "The Last. Word on the Wage Curve? 

Jour-nal of Economic Su:nwys 19: 421-50, 2005. Blanchflower and Oswald (The Wage Curve, p. 357) 

stated: "Futurf'; work will have to begin to test for statistically signif-icant differences among numbers that 

lie in a rough band from -0.05 t.o -0.20. It would probably he unwise to treat the minus-point-one rule as 

more than one of thunlbl'. 

21 D. Blanchfiower and A. Posen, "Wages and Labor !\Iarke!. Sla<'k: Making the Dual l\landat.c Operat.ional. 

Peterson Institute for International Ec:onomics Policy Brief 14-10, 2014. 

22Blanchflower and Posen, "\Vages and Labor !vfarket Sla.ck; A. Paciorek C:Where Arc t.hc Construction 

Workers? FEDS Notes, Board of Governors of the Federal Reserve System, February 26, 2015) found that 

many individuals who are out of the labor force appear to be relatively good candidates for construction 

employment, at least on the basis of their demographic charaeteristics. In partieular, he suggests there 

may be '~a large pool of pt"ople who would find construction work attractive but did not enter the industry 

during the bust years.'' 

23The results are essentially the same in Table 2 using weekly earnings. 

15 
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FIGURE 7 

A Stylized Representation of the Wage Curve 

Nominal \V~e Growth 

Unemployment Rare 

Note: The shadcrl area depicts the range for nominal wage growth that .Federal Reserve Chair Yellen has 

described .as '(normal.'' Source: authors' calculations. 

of labor market slack appear to be crueial in interpreting the sluggishness of nominal wage 

growth over the past few years, as shown in Figure 124 

Figure 7 presents our interpretation of the relationship between nominal wage growth and 

the "true unemployment rate (including underemployment and nonparticipation). In particular, we suspect that the wage curve is relativdy flat at elevated levels of labor market 

slack, i.e., a decline in slack docs not generate any signifieant wage pressures t1s long as the 

level of slack remains large. As noted above, our benchmark analysis indicates that the true 

unemployment rate is currently around 7! percent-a notable decline from its peak of more 

than 10 pen:ent but still well above its longer-run normal level of around 5 percent;. Thus, 

the shape of the wage curve can explain why nominal wage growth has remained stagnant 

at around 2 percent over the past few years even as the employment gap has diminished 

substantially. Moreover, our interpretation suggests that nominal wages will not begin to 

accelerate until labor market slack diminishes substantially further and and the true nncm24SN' D. Bdl and D. Blanchflower C'How to !'\'Ieasure Und('r<'mploymr-nt? P('trrson Institute for Intcrnat.ional 

Economics Working Paper 1:3/2, AuguBt 2013; "Underemployment in the CK Revisited, National Institute 

FJconomic Revir:w, 224: F8-F22, 2013; "Labour l\1arket Slack in the UK, National Instit'ute Economic Review, 229:F4-F11, 2014) for mon~ on underemploymcl!t. in the United Kingdom ba..qed on preferences over 

hours. \Vorkers are asked in t.he Lahour l:'Orce Survey, whkh is the equivalent of the CPS in the United 

States, if they want more or less hours. These responses can be aggregated to the economy level. From 

2000 to 2008 there wa.s 110 underemployment as the number of hours of those \vho wanted more hours 

approximately equaled the number of hours of those who want fewer hours. Since 2008 the numbers who 

want more hours dominate to such a degree that undercmploymeut currently is approximately 1.8 percPnt 

on top of the unemployment rate itself. It also turns out that one-third of the extra hours currently come 

from full-time workers, suggesting the measure we use iu the US is an underestimate of the true amount 

of underemploymt?nt by around 50 percent. 

16 
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ployment rate approaches its longer-run normal level of around 5 percent. 

Monetary Policy Implications 

No macroeconomic model provides a completely satisfactory description of any economy in 

the real world. Indeed, the limitations of existing macroeconomic models have been underscored by the incidence of relatively large and persistent forecast errors in many advanced 

economies over the past few years25 Thus, rather than relying on the monetary policy implications of any single macro model, it seems sensible to consider simple reference rules 

that provide reasonably robust performance across a range of plausible models. Such rules 

can serve as valuable benchmarks in the decision-making process and in explaining those 

decisions to the public. 26 

Following the seminal analysis of Taylor, a simple rule-of-thumb for adjusting the level of the 

federal funds rate can be expressed as a weighted sum of four components: the equilibrium 

real interest rate, the actual inflation rate, the inflation gap (that is, the deviation of inflation 

from the central banks inflation objective), and the level of resource slack. 27 \Ve discuss each 

of these components in turn. 

The equilibrium real interest rate (T') is defined as the short-term real interest rate at which 

the economy evolves along its balancC'd-growth path and inflation remains stable at the 

central banks objective. As with other properties of the balanced-growth path, the value of 

r* cannot be directly measured hut must be inferred from observed economic and financial 

data. In our analysis, the value of r' is given by the consensus outlook in the Philadelphia 

Feds Snrvey of Professional Forecasters (SPF) regarding the 5-to-10-year ahea.d projection 

for the average value of the :)-month Treasury hill rate less the PCE inflation rate. Thus. 

using the results of the latest SPF (published in }"'ebruary 2015), we set 1"' 1.25 percent ~ 

Inflation and the inflat-ion gop. The FOMC ha.<; established an inflation objective of 2 percent, 

expressed in terms of the price index for persona.! consumption expenditures (PCE). In 

measuring a.ctual inflation, we mitigate tlw influence of transitory price shocks by focusing 

on the 12-rnont.h percent change in the core PCE price index (that is, excluding food and 

energy prices). In the latest reading, this measure of inflation was 1.:n percent, and hence 

25See C. Romer and D. Romer, ·~l")rogTBm Heport: The NI3ER I\1oneta.ry Eeonomics Program, National 

Bun'a.u of Ecouomie Research Report 1,17, 2014. 

26Sce J. Taylor, "Discretion Versus Policy Rules in Prklctire, Carnegie-Rochester Conference Series on Public 

Policy 3~):195214, 1993; .L Taylor and .J. Williams, "Simple and Robust Rules for ;>.1onetary Policy, Handbook of Monetary Economics, 2010; A. Levin and .J. Taylor, ''Falling Behind the Curve: A Positive Analysis 

of Stop-Start Monetary Policies and the Great Inflation, iu The Great Inflation, Bordo, M., Orplumidf's, 

A .. eds., Chica~o, IL: University of Chk:ago Press, 201:1; a.nd A. Levin, "The Design and Communication 

of Systematic. Monetary Policy Strategies. 

27 Spcdfically, such a rule can be expressed <:l..S follows: it r" + rr1. + o(r.t - 1r'") + /3gap1, where it denotes 

the target federal funds rate, r* denotes thP equilibrium real interest rate, Trt denotes a smoothed measure 

of inflation, n* denotes the inflation objective, gapt is a rneasurE' of resource slack and the coefficients n 

and ,3 indicate how mueh the int~~rest ratt~ should be adjusted in response to the inflation gap (nt ~ rr") 

and to resource slack, respectively. Sec .J. Taylor, ''Discretion Versns Policy Rules in Practice. 

28This value of the equilibrium real interest rate is about. 25 basis points lower than the median of F'OMC 

participants longer-run real interest. rate projections in the latest SEP (published in mid-March). 

17 
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TABLE 3 

Prescriptions of the "Balanced Approach" Rule 

under Alternative Assessments of the Employment Gap 

Employment True Funds Rate 

Assessment Unemp. Rate Prescription 

Benchmark Estimate 1.9 7.4 0.29 

Lower Natural Rate 2.2 7.7 -001 

(4.8 percent) 

Higher Potential Labor Force 3.6 9.1 -1.44 

(CEO 2013) 

Higher Potential Labor Force 3.9 9.4 -1.74 

and Lower Natural Rate 

Source: BLS, Blue Chip Econmnic Indicators, CBO. SPF, and authors' C'akulations. 

the inflation gap was 0.69 percent. 

Re8ource slack. In light of onr foregoing analysis, we measure resource slack in terms of the 

total employment gap. In addition to our benchmark estimate, we consider the implications 

of several alternative assessments of labor market slack. 

For the sake of brevity, our analysis focuses on one specific rule-of-thumb that was analyzed 

extensively by Taylor. 29 This rule prescribes the level of the federal funds rate as the weighted 

sum of the equilibrium real interest rate, the current inflation rate, the inflation gap, and 

the level of resource slack, with weights of 1.0, 1.0, 1.5, and 1.0, respectively. This particular 

specification has been shown to provide a reasonably balanced approach to fostering the 

stability of inflation and economic activity, and hence Yellen characterized it as the "balanced 

approach rule.30 

As shown in 1:qblc :3, this policy rule prescribes a target f(~deral funds rate of about ~ 

percent using our benchmark estimate of the employment gap. However, the implied funds 

rate is notably lower for other reasonable tt,sessments. Indeed, using CBO's February 2013 

project.ion for the potential labor force (as depicted in Figure 4) along with a natural rate of 

4.8 percent (cousistent with analysts pre-crisis projections), the employment. gap is uearly 

twice as high at around '1 percent, and the funds rate prescription is nearly 2 percentage 

29 J. Taylor ('~A Historical Analysis of Ivlonetary Policy Rules, in J. Taylor, ed., Monetary 

University of Chicago Press, 1999) reported on a comprehensive analysis of the performance 

policy rules across a wide range of macroeconomic models. 

:{0Yellen, '

1

Perspectiv(>S on tvlonf'tary Polley. 

Rules; 

simple 

18 
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points below zero. 

This analysis indicates that initiating the process of monetary policy tightening would be 

premature at the present time. 1 ndeed, such a policy move would be a serious mistake in 

light of substantial downside risks to the currC'nt economic outlook. Rather, liftoff from the 

zero lower bound should be deferred until labor market slack has diminished further and 

iHfhttion has moved up closer to the FOIV1Cs 2 percent inflation goal. 

19 
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Making the Federal Reserve Fully Public: 

WhyandHow 

Jordan Haedtler, Andrew Levin, and Valerie Wilson* 

August 2016 

Abstract: The Federal Reserve's governance structure is outdated and inadequate for ensuring that the 

Fed serves the public interest. In this paper, we examine the case for making the Fed fully public ("why"), 

and then we consider specific proposals for doing so (''how"). Our analysis indicates that pragmatic and 

nonpartisan retonns can strengthen the Federal Reserve's governance while enhancing its operational 

independence to pursue its statutory mandate without political interference. In particular, the Fed should 

be a fully public institution whose decision-makers are selected by open and transparent processes; 

indeed, we find that making the Fed fully public also yields significant benefits for American taxpayers. 

Moreover, the Fed should be held to the same standards of transparency and accountability as every other 

public agency, including comprehensive annual reviews by the Government Accountability Office (GAO) 

and applicability of the Freedom of Information Act (FOIA) to all aspects of the Fed's procedures and 

operations. 

~ Hacdtler is the campaign manager of the Fed Up Coalition, Levin is a professor of economics at Dartmouth College, and 

Wilson is director of the Economic Policy Institute's Program on Race, Ethnicity, and the Economy. We appreciate very helpful 

comments, suggestions, and background research t}om Maggie Corser, Ady Barkan, Dean Baker, Josh Bivens, Jared Bernstein, 

and Bill Spriggs. 
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I. Introduction 

When the Federal Reserve System was founded in 1913, its fundamental purpose was to serve as the 

"bank to the bankers "-that is, a secure depository for bank reserves and a source of funds during 

liquidity sh01tages. Thus, like nearly every other central bank of that era, the twelve regional Federal 

Reserve Banks were established as essentially private institutions, owned and managed by commercial 

banks under the broad oversight of the Federal Reserve Board (which is an independent federal agency). 

Over the past century, however, the Federal Reserve has evolved into America's central bank, and its 

monetary policy decisions now affect the everyday lives of practically every American family. For 

example, when the Fed acts to adjust the level of short-term interest rates, that adjustment is reflected in 

a wide array of interest rates and asset prices, including auto loan rates, home mortgage rates, savings 

deposit rates, business financing costs, and so forth. And those financial effects reverberate on the broader 

economy, affecting consumer spending, business hiring and investment, and the determination of wages 

and prices. 

Unfortunately, the Federal Reserve's governance structure is outdated and inadequate for ensuring that 

the Fed serves the public interest. The presidents of the Federal Reserve Banks sit on the Federal Open 

Market Committee (FOMC), which determines the course of monetary policy, but the Federal Reserve 

Banks are private institutions owned by commercial banks. Indeed, commercial banks select two-thirds 

of the directors of each Federal Reserve Bank, including half of the directors responsible for appointing 

its president. Moreover, while the demographics of America have grown increasingly diverse over time, 

the leadership of the Federal Reserve Banks (that is, the presidents and the directors) has remained 

overwhelmingly white, male, and insular-Dominated almost exclusively by long-time Fed insiders 

and individuals with a tinancial background. 

Moreover, the Fed's private ownership is now out of step with practically every other major central bank 

around the world. For example, the Bank of Canada and the Bank of England became public in 1938 and 

1946, respectively, while the European Central Bank has been a public institution since its inception in 

the 1990s. Nearly all of the 19 national central banks in the eurozone are fully public; the lone exceptions 

are Belgium, Greece, and Italy. And the Bank of Japan and the Swiss National Bank each have miniscule 

amounts of outstanding shares, the majority of which are held by other public institutions.' 

In this paper, we examine the case for making the Fed fully public ("why"), and then we consider specific 

proposals for doing so ("how"). Our analysis indicates that pragmatic and nonpartisan reforms can 

strengthen the Federal Reserve's governance while enhancing its operational independence to pursue its 

statutory mandate without political interference. In particular, the Fed should be a fully public institution 

whose decision-makers are selected by open and transparent processes; indeed, we find that making the 

Fed fully public also generates significant bene!lts for American taxpayers. Moreover, the Fed should be 

held to the same standards of transparency and accountahility as every other public agency, including 

comprehensive annual reviews by the Government Accountability Office (GAO) and applicability of the 

Freedom of Information Act (FOIA) to all aspects of its procedures and operations. 

1 The paid-in capital of the Bank of Japan (BOJ) is fixed at a miniscule amount of I 00 million yen (roughly $1 million) that 

accrues a tiny stream of dividends (about $50,000 per year). Moreover, the Japanese government owns 55 percent of the BOJ's 

paid-in capital, and its other shareholders do not have any role in the BOJ's oversight or management. The paid-in capital of the 

Sv,riss National Bank is fixed at 25 million CHF (about $25 million), of which roughly two-thirds is held by public institutions. 
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2 

II. The Rationale for Fed Reform 

A. Deficient Selection Procedures 

As noted above. the FOMC sets the nation's monetary policy. Under the Federal Reserve Act, the FOMC 

has a nuanced structure in which the seven members of the Fed's Board of Governors and the president 

of the Federal Reserve Bank of New York are all permanent voting members, while four of the other 

eleven presidents serve as voting members on a rotating basis. That design was intended to ensure that the 

Federal Reserve Bank presidents-as heads of private institutions-would only constitute a minority of 

the voting members of the FOMC. In recent years, however, the Fed's Board of Governors has regularly 

experienced multiple vacancies, reflecting a more extensive timeframe for vetting potential nominees a~ 

well as a more protracted duration of the Senate confirmation process. Thus, the members of the Board of 

Governors have constituted a voting mi\jority at only half of the FOMC meetings from 2001 to 2008 and 

less than one-third of the FOMC meetings since then.2 ln effect, increased political gridlock ha~ expanded 

the intluence of the Federal Reserve Bank presidents in setting the nation's monetary policy3 

Despite the crucial role of Reserve Bank presidents in determining the nation's monetary policy, the 

process for selecting them takes place entirely behind closed doors. Recent Reserve Rank presidential 

appointments have revealed a process that is opaque, inbred, and largely proforma. The Federal Reserve 

Act establishes the procedure for selecting Reserve Rank presidents. The Federal Reserve Board describes 

the process as follows: ''To conduct the search, the Reserve Bank's hoard of directors forms a search 

committee composed of Class B and C directors. That committee hires a search firm to help identify a 

broad, diverse, highly qualified candidate pool. The committee considers a large nationwide pool of 

candidates, both within and outside the Federal Reserve System, who meet the position's qualifications. "4 

Beyond these legal guidelines, very little information is publicly available regarding how Reserve Bank 

presidents are chosen. The public is kept in the dark about the candidates heing considered, the time line 

for their selection, and the criteria used to assess candidates' qualifications. When the Reserve Bank 

presidents in Philadelphia, Dallas, and Minneapolis announced their retirements in 20!4, the stage was set 

for a preview of the re-appointment process set to take place in 2016. One by one, the presidential 

vacancies at all three Reserve Ranks were filled by individuals who had previously been affiliated with 

the same large bank, and the Board of Governors unanimously approved each of those appointments:' 

At the Dallas and Philadelphia Reserve Banks, the individuals chosen had heen involved in their own 

selcction6 

These, however, are not the only examples of Reserve Bank presidents having an inside track to selection. 

A 2015 analysis conducted by the Bipartisan Policy Center found that 17 of the 25 Reserve Bank 

2 Indeed, there have been three FOMC meetings at which tl1ere were only four members of the Board of Governors, and hence 

they comprised a minority of the voting members of the FOMC. 3 hfm:~.:www. hrookings.edul-;media 1

researchl(ifes 'papers 120 15'03/02-(ed-banks-21 stcentun/pcb workinwaoer) 0 june24 final. pdf. 4 hllps:/lwww.kderalreserve. gov/faqs,how-is-a-federal-resen'f-bq!11::J2Lesident-selecte.ci. IUlJl. 5 https:.:~'www.thenation.comlarticle/;vhy-do-!Ormer-goldman-sachs-bankers-keep-landing-for-slots-at-the-federa!-reserve' 6 http:/ '1tww. bloomberg_r.;_om/neH's/artic/es/20 I 5-06-03/not-(ar-to-lf22.!s::[ed-s-newest-president-searched-f0und-himself: 

http:l bi::Q_eatblog.rfgjlasnews.com'20J5;0S.'dall@:ie.4::11{1_!.1J.f!J...·:lJ..q~:,·ard-businf~liJ_j_essor-as-nelJ:::J2If!Sident.html 1 
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3 

presidents since 1990 "have been immediate past employees or board members of a regional bank." 7 

In response to recent concerns members of Congress raised about the re-appointment process for 

Federal Reserve Bank presidents being an "inside game," leaders at the Fed noted that the Board 

of Governors conducts ''ongoing monitoring" m1d an annual review of Reserve Bank presidents' 

performance, and that when the time came to re-appoint or replace presidents, the Board of Governors 

would "act on the recommendations" of the boards of directors. 8 In 2016, all Reserve Bank presidents 

were re-appointed to new terms9 

The re-appointment process is proforma and insular. Indeed, Federal Reserve Bank presidents do not 

conceive of their own appointments as having five-year terms; rather, they mostly expect to serve until 

they retire or are aged out. One example of the process' perfunctory nature is the routine re-appointment 

of presidents who can't possibly serve the bulk of their term due to mandatory retirements. 

To ensure that a wider breadth of candidates-not just those with backgrounds at the Fed and within the 

financial sector-are considered, the Fed must bring this process out from the shadows. 

B. Lack of Diversity 

In 1977, Congress amended the Federal Reserve Act to include reforms requiring that Federal Reserve 

leaders "represent the public, without discrimination on the basis of race, creed, color, sex, or national 

origin, and with due but not exclusive consideration to the interests of agriculture, commerce, industry, 

services, labor and consumers." 

Despite these effmts to fonnally align the institution with current antidiscrimination laws and to expand 

diversity on Federal Reserve Bank boards of directors, the Federal Reserve remains wholly 

unrepresentative of the public, in terms of racial, gender, and professional diversity: 

• No African American or Latino has ever served as president of any Federal Reserve Bank. 

• At present, ten of the twelve Federal Reserve Bank presidents are white men; two are women, 

and only one is non-white. 

• The directors of the Federal Reserve Banks are predominantly white men; specifically, 

83 percent are white and nearly three-fourths are men. 

About five years ago, the GAO reported that consumer groups and labor organizations were 

significantly underrepresented on Federal Reserve Banks' boards of directors. 10 Since then, 

however, the share of directors from banking and commerce has increased even further. 

• Less than 5 percent of all Federal Reserve Bank directors represent organizations governed 

by community members and employees. 
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4 

C. Consequences for Decision-Making 

Diversity is more than just a symbolic gesture of fairness and inclusion. Empirical analysis clearly shows 

that diversity, especially within public organizations, enhances the pursuit of policies and practices that 

meet a broader range of public needs and expectations and even improves organizational performance.'' 

This operates through direct as well a~ indirect channels. When included in decision-making roles, 

members of underrepresented groups tend to act to ensure that the interests of those who share their group 

identities are not overlooked. Additionally, their presence in these roles also influences non-minority 

decision-makers by exposing them to information that may be beyond the scope of their personal 

experience. 

The advice of Federal Reserve Bank directors and the background of Federal Reserve Bank presidents are 

undoubtedly key factors that contribute to the FOMC's deliberations. The attitudes, perspectives, and life 

experiences that Federal Reserve Bank presidents and board directors take to the FOMC have an 

enormous bearing on the Federal Reserve's decisions, which in turn have major implications for public 

well-being. The outsized voice of the commercial banks in selecting regional Federal Reserve directors 

significantly affects the capacity of the Federal Reserve Banks to fulfill their responsibility for assessing 

and characterizing economic conditions in their respective regions. And the resulting lack of diversity of 

the Federal Reserve Bank presidents-in terms of race, ethnicity, gender, educational background and 

professional experience--haq substantive consequences for comprehensively and accurately assessing the 

strength of the economy in advance of making monetary policy decisions. 

Of course, the Fed is not charged with alleviating the full range of structural factors that lie at the root of 

racial inequality, and its monetary policy tools would be poorly suited to address those factors. However, 

monetary policy actions can significantly affect the pace of an economic recovery and hence have effects 

on employment and wages by shifting the balance of power between workers and employers. These 

effects tend to be disproportionately large for specific demographic groups because tighter labor markets 

also make it more costly for employers to discriminate. Thus, it is appropriate for the Fed to consider 

those etiects in setting the course of monetary policy, but the transcripts ofFOMC meetings provide 

little evidence that Fed officials have actually done so. 

In particular, African American workers suffer disproportionately from labor market downturns and 

benefit markedly from economic recoveries. The unemployment rate for blacks typically moves twice as 

much as the national unemployment rate. 12 And the unemployment rates of black teenagers and young 

adults--especially those without a college degree-are even more sensitive to shifts in the stance of 

monetary policy .

13 Nonetheless, even as national unemployment hovered at crisis levels in 20 l 0, the 

FOMC meeting transcripts reveal that Fed officials never made a single reference to the abysmal labor 

market conditions of African Americans." 

11 J.J. Hindcra.. Representative bureaucracy: Fmther evidence of active representation in the EEOC district offices, Journal of 

Public Administration Research and 7heory 3(4):415-429, 1993. S.E. Page. The difference: How the power of diversity creates 

better groups, firms, schools and societies, Princeton University Press, 2007. S.C. Selden. l11e promise of representative 

democracy: Diversity and responsiveness in a government agency, M.E. Sharpe, 1997. 12 http.-i/www.fJ2L.Qcgj}ublication the-impact~o(:full~emplovment~on-akican-american-e..mplQJ}nent-and-'ff&§f 

u http:/ 'www. npc.umich. edu/publications/working paperslpaperl 0/03-1 Orev2.pd{ 14 bJJQs;_;j)jjes.google.com/site/kocherlakota009/home/policr/thouglus-on~ooli_q/l-18-!6. In 2010 the unemployment rate 

for African Americans exceeded 15 percent-more than 5 percentage points higher than the national unemployment rate. 
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To see the positive side of these dynamics, it is helpful to revisit the experience of the late 1990s. By 

2000. the average annual unemployment rate had fallen to 4 percent-its lowest level in generations, and 

the deviation between unemployment rates for blacks vs. whites was only 4. I percent-notably smaller 

than in the 1980s or the 2000s. In addition to these substantial employment gains, the real wages of 

black workers grew by 2 percent per year during the late 1990s-a tad faster than the wage growth of 

1.7 percent per year for whites [FigureD from Full Employment tables &figures.xlw]. These 

employment and wage gains translated into improved living standards for African American households. 

The share of African American households in the middle 60 percent of the income distribution rose 

3 percentage points between 1995 and 2000, whereas that share declined during the recoveries of the 

1980s and the 2000s. 

It is important to note that these desirable outcomes stemmed from a full employment economy without 

any acceleration in the rate of inflation, suggesting that policymakers should be willing to experiment 

aggressively with low rates of unemployment for the sake of improving conditions in some of America's 

hardest-hit communities without undue concem about keeping inflation rates in check. Such 

considerations may be more likely to occur among a group of policymakers who are familiar with the 

wide range of economic outcomes in an increasingly diverse and unequal society. 

The Fed's lack of sectoral diversity is also a problem. When major corporate figures from a variety of 

industries are included on the Reserve Banks' boards, the Fed considers its requirement to represent an 

array of economic interests fulfilled. But multi-millionaire CEOs have an inherently different 

understanding and perspective than small business owners, debtors, students, middle- and low-income 

workers, and those seeking credit. 15 In practice, that lack of diversity has frequently skewed concerns 

within the Fed toward inflation and down played the importance of achieving full employment. Indeed, 

Baker and Bernstein (2013) analyzed the deviation of unemployment from its full-employment level 

and found that the cumulative gap from 1980 to 2012 was about 3 I percentage points. 

Finally, the Fed's current governance structure contributes to a "group-think" approach that may explain 

why policymakers failed to recognize key warning signals prior to the onset of the financial crisis. Indeed, 

Greider (2014) notes that " ... reliance on a narrow frame of reference produces institutional blind spots and 

gross errors ... The telling evidence lies in what the Fed does not talk about.lfyou scan the public record 

over the last generation, you might conclude that the policy-makers were unaware of the grave disorders 

that were steadily accumulating. Or that they believed the economic pressures assaulting citizens were 

not relevant to monetary policy. Whatever the explanation, the Fed missed the big story-the steady 

economic deterioration stalking the middle class-just as it did not see the reckless behavior in banking 

that would lead to collapse." 

15 http:i 'l.r-a·w. bi=journals.com/twincities/news/20 15/08ll9/general~milfs~cJz.9-ken-powell-pav-fm•offs. html 
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III. Strengthening the Fed's Governance 

Legislative action will be required to make the Federal Reserve into a fully public institution. Of course, 

amending the Federal Reserve Act is a delicate matter. and it is crucial to ensure that such legislation 

strengthens the Fed· s governance and enhances its operational independence to carry out its statutory 

mandate. In this section, we provide a detailed analysis of the governance reforms proposed by Levin 

(20 J 6), and then we compare this approach to the proposals of Conti-Brown (20 15) and Fisher (20 16). 

A. Ownership 

Current Law. Each regional Federal Reserve Bank is a private institution that is legally owned by 

commercial banks-referred to as member banh-whose headquarters are located within its district. 16 

Indeed, the Federal Reserve itself refers to the member banks as "stockholders" who purchase shares 

of equity and thereby supply the Fed with paid-in capital." Those shares cannot be transferred or sold; 

i.e., each Federal Reserve Bank is in essence a privately-held corporation. 

The equity issued by each Federal Reserve Bank-and hence the amount of its paid-in capital-is 

determined by the equity of its member hanks. Specifically, each member bank is required to provide 

paid-in capital to the Fed that is equal to three percent of its own equity (that is, its capital plus surplus). 18 

If a memher bank's equity increases, then it must purchase a corresponding amount of additional shares 

from its Federal Reserve Bank. Conversely, if a member bank is liquidated or its equity shrinks, then the 

Federal Reserve Bank cancels the corresponding an10unt of shares and refunds that amount back to the 

member bank. 

As with many privately-held corporations, each Federal Reserve Bank pays dividends to its shareholders. 

Under current law, the dividend rate for the larger member banks (assets exceed $10 billion) is given by 

the yield on 10-year U.S. Treasury notes, while the smaller member banks (assets less than $10 billion) 

receive a fixed dividend rate of6 percent. 19 As of year-end 2015, the Fed's paid-in capital totaled $29.5 

billion, of which $27.4 billion was provided by the larger member banks, and $2.1 billion was provided 

hy the smaller member banks20 

Proposed Reform. All of the regional Federal Reserve Banks should become public corporations that are 

fully owned by the American people. This transformation would be remarkably straightforward, because 

the Fed can simply follow the procedures that it already uses for making adjustments to the shares of 

individual member banks. Each Federal Reserve Bank will cancel all of the shares of its member banks 

and refund their paid-in capital along with the prorated amounts of any accrued dividends; those relunds 

will be issued by crediting each bank's account at the Federal Reserve Bank. 

10 All nationally-chartered banks are required to be members of the federal Reserve System. Such membership is voluntary for 

state-chartered banks, but in practice only a fCw small banks decline that option. 17 !JJ.!JlJ..:/www. te..s;lerafr_gg.rt.:s:.:.gov 1

newsevenJs/vress/bcrgg::_Qs;n:gl0 160218a ].pdf 18 Under cunent law, the Board of Governors has authority to call on each member bank to provide additional paid-in capital up 

to a maximum of6 percent of its own equity; however, that provision has never been used in practice. 19 These dividend rates became effective on January I, 2016; prior to that date, all member banks acc111ed dividends at the fixed 

rate of 6 percent. 20 The total amount of paid-in capital is shown in the .. Federal Reserve Banks Combined Financial Statements'' of 

the Federal Reserve's annual report (http:/·www.kderalreserve.govlpublicationslannual-renort/2015-contents.!Jlm). The subtotals 

corresponding to large member banks and smaller member banks, respectively, were obtained from the fDIC database of 

'·Statistics on Depository Institutions" (/lttps:l/www5.fdic.f!ov/sdi). 
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This approach to making the Federal Reserve fully public does not involve any change at all in the current 

value of U.S. government debt. Moreover, this measure will not have any effect on the size of the Fed's 

balance sheet but will simply modifY the composition oft he Fed's liabilities. In effect, the Fed will be 

paying off one form of liability-namely, member banks· paid-in capital-by expanding another type 

of liability, namely, member banks' reserves held at Federal Reserve Banks. 

Indeed, this measure will augment the Fed's net income, because the stream of dividend payments is 

much more costly than paying for the equivalent amount of bank reserves held at the Fed. For example, 

the dividend rate that the Fed pays to the larger member banks (i.e .. the 1 0-year Treasury yield} is now 

close to 1.5 percent-roughly a percentage point higher than the rate of interest that the Fed currently 

pays on bank reserves. Of course, the precise magnitude of this spread varies somewhat over time, but the 

consensus of professional forecasters is that tl1c spread will remain roughly unchanged over the coming 

decade21 As for the smaller memher banks, the interest rate on reserves is currently far below the fixed 

dividend rate of 6 percent, but that spread is expected to narrow over time as the level of short-term 

interest rates moves gradually upwards. 

Thus, making the Federal Reserve fully public will generate significant ben4itsfor American taxpayers, 

because the Fed generally transfers all of its net income to the U.S. Treasury .

22 For example, at the current 

level of interest rates, the annualized amount of the Fed's dividend payments is about $540 million. 21 

By transfonning its paid-in capital into bank reserves, the Fed would instead pay about $150 million in 

interest. In effect, this transformation would increase the Fed's annual net income by nearly $400 million 

per year. Even with the level of interest rates rising gradually over time, the benefit to taxpayers will 

continue to exceed $300 million per year. 

Indeed, if we cumulate the annual amounts over the coming decade, the savings to taxpayers from making 

the Fedfitlly public is likely to be well over $3 billion. As we have already emphasized. the fundamental 

rationale for making the Fed public is to enhance its governance, accountability, and transparency. 

Nonetheless, the magnitude of these fiscal benefits is substantial and thereby makes the case tor enacting 

this refonn even more compelling24 

2l The Federal Reserve Bank of Philadelphia regularly collects professional fOrecasters' projections of the longer~n.m average 

level of interest rates (!mps:/l1fww.philadelphiakd. oro/re.rg_qn:;lJ-qntfrJ.qJa/real-!i!!..!JL:fJ;lJ.!£.r~<>urvev-o(-pJ:Q[gt!l.Qnal-forecas{t;J.:2. 

fn the most recent projections (published la<>t February), the median projection was 2.5 percent for the 3-month Treasury bill rate 

and 3.4 percent for the 10-year Trea.<:ury yield~ i.e., the spread between those rates is expected to average 0.9 percent over the 

next decade-just a notch lower than the current spread. 22 Under current law, the Federal Reserve maintains a surplus capital account that is capped at $10 billion, and any net income 

exceeding that amount must be remitted to the U.S. Treasury. The Fed's net inwme has remained positive throughout its history, 

but if its net income ever tumed negative the Fed would draw down its surplus capital and suspend the transfer of funds to the 

U.S. Trea.:;ury. 23 As noted above. the Fed is currently paying a dividend rate of about 1.5 percent on the $27.2 billion of paid-in capital provided 

by the larger member hanks and a fixed dividend rate of 6 percent on the $2.3 billion in paid-in capital provided by the smaller 

member banks~ consequently, those annual dividends are about $410 million and $140 million. respectively. By transfom1ing all 

of its paid-in capital into bank reserves, a fully public Fed would instead pay its current interest rate of 0.5 percent on those bank 

reserves. 

14 Making the Fed fully public may also he viewed positively by commercial banks, because the Fed would refund all of their 

paid-in capital, which the banks could then invest in the broader economy. Indeed, that is precisely the rationale for 1-LR. 5027, 

a bill recently proposed by Rep. Neugebauer that would return most (but not quite all) of the Fed's paid-in capital to the banks. 
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B. Appointment of Federal Reserve Bank Officials 

A key element of making the Fed fully public is that the appointment of Federal Reserve Bank officialsthat is, directors and presidents-should occur through an open and transparent process that provides 

extensive opportunities for public input. 

Directors. Each Federal Reserve Bank should continue to be overseen by a board of nine directors who 

serve staggered three-year terms. Under current law, the member banks select six of those directorsnamely, three employees of member banks, and three individuals not employed by any member bankwhile the remaining three directors are appointed by the Fed's Board of Governors. In contrast, once the 

Fed becomes fully public, it would no longer be appropriate for the commercial banks to have any special 

role in selecting any of the directors. Instead, all of the directors should be selected through a process 

overseen by the Board of Governors and involving elected officials of each Fed district. 

A fundamental reason for the Fed's regional structure is to ensure that the nation's geographical diversity 

is reflected in the Fed's monetary policy decisions. Thus, every candidate for director should be 

nominated by at lea<>t one senior elected official--either a governor or member of Congress-from the 

geographical area covered by that particular Federal Reserve Bank. The Board of Governors would 

appoint a search committee to narrow down the list of candidates a'> needed, and then the Board of 

Governors would make the final decision through a recorded vote. 

The appointment process should ensure that directors are broadly representative of the public in terms of 

racial/ethnic and gender diversity, educational background, and professional experience. The majority of 

directors on each board should be affiliated with small businesses and non-profit organizations, including 

community and consumer groups, labor unions, and academic institutions. To avoid conflicts of interest 

and protect the integrity of the Federal Reserve's role in regulating the banking industry, individuals 

affiliated with financial institutions overseen by the Fed should be prohibited from serving as directors. 

To ensure a sufficiently high degree of transparency, the appointment process would include the 

following elements: (i) publication of the selection criteria and time line; (ii) public forums at which 

members of the public can meet with the search committee; (iii) publication of the names of all candidates 

under consideration; and (iv) opportunities for members of the public to submit questions to the 

candidates, either electronically or at a public forum. 

Presidents. The board of directors of each Federal Reserve Bank should maintain responsibility for 

appointing and overseeing its president. Under current law, that appointment is made by only six of the 

directors, namely, the three non-bankers chosen by the member hanks and the three individuals appointed 

by the Board of Governors. In contrast, once the Fed becomes fully public, all nine directors would he 

responsible for making that decision. 

To ensure a high degree of transparency, the process of appointing Federal Reserve Bank presidents 

should be reformed so that each board of directors takes nominations from the public, publishes a list of 

all eligible nominees, and engages in a selection process involving genuine public participation through 

public forums and other forms of input and feedback. 
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C. Terms of Office 

Terms of office play a crucial role in ensuring that a central bank has an appropriate degree of operational 

independence and accountability. If the term of office is fairly short and subject to renewal, then 

policymakers may be susceptible to political interference that could impair the central bank's ability to 

carry out its statutory mandate. Conversely, it would not be appropriate for central bankers to have 

permanent lifetime appointments, because the central bank is an agency with delegated authority, 

not an autonomous branch of government like the judiciary. 

In their comprehensive study of central bank independence and transparency, Eichengreen and Dincer 

(2014) have noted tlJat the international best practice is for monetary policymakers to be appointed to a 

single nonrenewable term that exceeds the length qfthe political cycle. 25 Indeed, that standard is already 

followed by several other major central banks. For example, the president of the European Central Bank 

and the governor of the Bank of England each serve a single nonrenewable term of 8 years, while the 

governor of the Bank of Canada has a 7-year term26 

By contrast, the current terms of office of Federal Reserve policymakers are not consistent with that 

standard. The Federal Reserve's Chair is appointed to a renewable term of 4 years, and hence the question 

of whether a current Fed chair will be reappointed has occasionally arisen as an issue in U.S. presidential 

campaigns.27 The members of the Fed's Board of Governors are appointed to staggered 14-year tenns, but 

in practice tl1eir tenure has averaged only about 4 years.28 Finally, as previously noted, the Federal 

Reserve Bank presidents have renewable 5-year terms, but in practice their reappointments have been pro 

forma and hence they typically hold office for two decades or more. 

Thus, making the Fed fully public provides a crucial opportunity to strengthen the Fed's operational 

independence and accountability. Every Fed policy maker-including the Chair, the Vice Chairs, the other 

members of the Board of Governors, and the presidents of the Federal Reserve Banks-should have a 

single non-renewable term of 7 years, and those tenus should be evenly staggered over time. Of course, 

some appointees may not end up serving a full 7-ycar term due to circumstances that could not be 

anticipated at the time of their appointment to office. Nonetheless, the vetting process should aim to 

ensure that every appointee intends to serve the full length of their term29 That constraint might be 

binding for some potential nominees who would otherwise be highly qualified. But fostering the Fed's 

25 See criteria 1a, 1 d, Sa.., and Se in Table 18 ofN. Dinccr and B. Eichengreen. '"Central Bank Transparency and fndepcndence: 

Updates and New Measures", International Journal of Central Banking, March 2014, pp.l89-253 {http:l'l'I'}±'W.iicb_grg}. 

:::6 Since 1987 each governor of the Bank of Canada has served a single term of office; that practice has been a matter of 

convention rather than a statutory requirement. 27 For example, Chairman Arthur Rurns was appointed by President Nixon in 1970 and reappointed by President Ford four years 

later, but the Fcd"s policies were questioned in the 1976 presidential campaign, and in 1977 Chainnan Bums tried unsuccessfully 

to persuade the Cmter administration to support his reappointment to a third tenn. [insert reference here/ Indeed, the issue of the 

Fed Chair's reappointment has arisen in the current campaign; sec [lttp:/iwwlJ!.JY..§.icom/a..r.ticlesldonald-tG~avs-he-would: 

replace-janet-vellep-sumwrts-low-;nterest-rates- 1462465158. 23 Under current law~ a member of the Board of Govemors may initially be appointed to fill out the remainder of someone else's 

14~year term and then reappointed to a full 14-year term; moreover, as noted above, the appointment of the Fed Chair is subject 

to renewal every kmr years. subject to the constraint that the Chair must be a memher of the Board of Governors. Consequently, 

a Fed Chair's tenure may also be very long, as in the cases of William Martin (1950- 1970) and Alan Greenspan (1987-2006). 29 For example, academic institutions typically a!lmv tenured faculty to take a leave of absence for up to two years; thus, a 

number of such individuals have been appointed to the Board of Governors and then resigned within 18 to 24 months in order to 

return to their academic positions. 
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operational independence is crucial to its effectiveness, and hence it is essential to ensure that the tenure 

of red policymakers extends beyond the length of the political cycle. 

D. Comparison with Alternative Approaches 

Proposals to make the Fed fully public have been debated since the 1930s. Generally speaking, such 

proposals have involved one of two approaches: (I) the r ederal Reserve Banks would be converted into 

branch offices of the Fed's Board of Governors. and their presidents would become employees of the 

Board of Governors; or (2) the Federal Reserve Banks would become part of the federal government, and 

their presidents would become federal officials appointed by the President and confirmed by the Senate. 

For example, Conti-Brown (2015) has advocated the first approach, while Fisher (2016) has proposed a 

comprehensive reform package that would incorporate the second approach. 30 Under either approach, the 

board of directors of each Federal Reserve Bank would no longer have any role in il<; governance and 

could be transformed into an advisory council or simply disbanded. 

Alternative#/: Making the Federal Reserve Bank presidents into employees of the Board of Governors 

would risk undermining the decentralized structure of the Fed and consolidating too much power in 

Washington, DC. As employees hired and fired by the Board of Governors, the chiefs of the Federal 

Reserve Banks could no longer be independent voices representing diverse perspectives and distinctive 

geographic regions. Indeed, the entire Fed might become even more susceptible to the "group think" 

problem noted above. 

Thus, rather than curtailing or abolishing the Federal Reserve Banks, it would be preferable to strengthen 

their effectiveness by making them fully public institutions. Involving the senior elected officials of each 

region in nominating the directors of its Federal Reserve Bank would help ensure that those directors are 

broadly representative of their entire region-not just its financial and corporate interests. Moreover, 

opening up the process of appointing the Federal Reserve Bank presidents would dramatically expand the 

public's ability to engage in that process at a grassroots level, rather than shifting all of those decisions to 

officials at the Fed's DC headquarters. 

Examining the experiences of other central banks around the world, the advantages of public central 

banks that encourage regional collaboration become clear. In countries where the population is mainly 

concentrated in a fairly small geographical area (such as Canada, Japan, Sweden, and the United 

Kingdom), the central bank's policymakers are appointed by the national government while its regional 

branch offices carry out purely administrative functions. By contrast, the Eurozone encompasses much 

greater regional diversity, and hence the European Central Bank (ECB) was intentionally designed to 

have a governance structure similar to that of the Federal Reserve. Thus, monetary policy for the 

Eurozone is determined by the ECB Governing Council, comprised of its executive board (whose 

members are appointed by a joint decision of the heads of all Eurozone countries) and the presidents 

of the 19 national central banks (who are appointed by their respective national governments). Indeed, 

that regional governance structure has proven crucial in enabling the ECB to face a number of daunting 

pol icy challenges over recent years. 

30 See http;/ii>alejre,&S'_Qm nc/do-the-banks~own~!he-fi:deral-resen:.f!::l.fi-S-finall;'-make-thf.:fl.!J/D:j!er-a-resounding-no-bv-peterconti-hr/ and lmv://shadow&d orv/wp-contem/uploads/20 16/0.J/FisherSOlv!C-Apri/20 J6.pd( 
88 

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Altemative #2. The presidents of the Federal Reserve Bank could become federal officials appointed by 

the President and confirmed by the Senate, thereby preserving their independent role in relation to the 

Fed's Board of Governors. However, shifting the appointment process to the federal level could lead to 

a greater number of Federal Reserve Bank presidents with political connections in Washington rather than 

deep and longstanding ties to their own Federal Reserve district. Indeed, the Board of Governors itself is 

already supposed to be comprised of individuals from diverse regions, but that legal requirement has 

rarely been considered in practice.31 

Moreover, expanding the number of Fed officials to be nominated by the President and confirmed by 

the Senate could be a recipe for a much greater incidence of vacancies among the Federal Reserve Bank 

presidents, similar to the problem faced by the Fed's Board of Governors in recent years. One way to 

avoid that particular pitfall would be to slash the number of Federal Reserve Banks, perhaps following a 

process similar to the approach used in determining military base closures at the end of the Cold War. 

Alternatively, as in the comprehensive reform package proposed by Fisher (2016), the Fed's Board of 

Governors could be scaled down to a single Chair while the number of Federal Reserve Banks would 

shrink !rom 12 to 8, so that the Fed would have a single decision-making body comprised of nine voting 

members-all of whom would be federal officials. Such an approach has substantial implications for 

how the Fed carries out its responsibilities for financial supervision and regulation, and hence a detailed 

analysis of that proposal would necessarily go well beyond the scope of our paper. 

IV. Strengthening the Fed's Transparency and Accountability 

Transparency and accountability are fundamental characteristics of every well-governed public agency." 

Moreover, the international experience clearly demonstrated that enhancing a central bank's transparency 

and accountability raises the public's confidence in the integrity of the monetary policy process and 

thereby strengthens public support for its operational independence in carrying out its legal mandate. 

In this section, we consider tbree key clements that would significantly improve the Fed's transparency 

and accountability, aligning its practices with those of other U.S. public agencies and with many other 

central banks around the globe. 

A. Public Access to Information 

Over the past half-century, the Freedom of Information Act (FOIA) has required that every federal agency 

must make its records "promptly available to any person," subject to a Jew specific exemptions that are 

intended to protect national security, individual privacy, proprietary business information, and predecisional agency deliberations. As a federal agency, the Fed's Board of Governors is subject to FOIA. 

By contrast, the twelve Federal Reserve Banks are private institutions that are not covered by FOIA. 

In fact, the Board of Governors has successfully argued in tederal court that it is obliged to protect 

31 The law states: "In selecting the members of the Board, not more than one of whom shaH be selected from any one Federal 

Reserve district, the President shall have due regard to a fair representation of the financial, agricultural, industrial, and 

commercial interests, and geographical divisions of the country.'' (/71tp:/'w·ww.federa!resene.gov/aboutthefed1

section%20JO.hun) 32 for further discussion, see h(tp:/i"regulationbodvofknmrledge.org/regulatorv-process'instillllional-d~' and 

!JJ.tp:/"www.Jr.orldbankorg/er'L/topic/oovemance/overview. 
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the secrecy of all Federal Reserve Bank records and guard against their disclosure33 The legal premise 

is that the Board of Governors is the federal agency that oversees the Federal Reserve Banks, and hence 

its responsibilities are the same as any federal agency that must protect the confidential information of a 

private institution. The federal court strongly endorsed that argument in its final ruling: 

" ... as the Board points out, the fact that it can require examination of the Federal Resen1e 

Banks is no different than any other financial institution subject to mandatory supervision 

by a federal regulator. If a financial institution cannot expect confidentiality, it may be less 

cooperative and forthright in its disclosures, even if an examination is mandatory. There is 

no reason to believe the Federal Reserve Banks would not react the same way. " 

U.S. District Court for the District of Columbia, Case 13-cv-603-tsc 

(Laurence M Ball vs. Board <?(Governors of the Federal Resen•e System) 

It is deeply troubling that a federal court has accepted the premise that the public release of their records 

could lead the Federal Reserve Banks to become "less cooperative and forthright" in their interactions 

with the Board of Governors. Unfortunately, that prospect is a direct consequence of the fact that the 

Federal Reserve Banks are currently structured as private institutions owned by commercial banks. 

That lack of transparency is inappropriate and unacceptable, because the Federal Reserve's fundamental 

purpose must be to serve the interests of the public. By converting the Federal Reserve Banks into public 

institutions, the entire Federal Reserve System will be covered by FOIA. Consequently, all of its records 

will become subject to prompt disclosure (apart from the standard exemptions), regardless of whether 

those records originated at a Federal Reserve Bank or at the Board of Governors. 

B. External Reviews 

Regular external reviews are a key element of good management for any institution, public or private. 

Indeed, such reviews have become standard practice at many central banks as well as global organizations 

like the International Monetary Fund:" For example, the Bank of England has a Court of Directors that 

has authority to examine all aspects of its activities, and those reviews are conducted by an Independent 

Evaluation Office that reports directly to the Com1 of Directors. 35 As noted above, such reviews 

strengthen the public's confidence in the effectiveness of the central bank and therehy enhance its 

operational independence from political interference. 

U.S. federal agencies are generally subject to two forms of extcmal review. First, each agency has an 

independent Office of the Inspector General that examines all aspects of the agency's procedures and 

operations, with the aim of identifying and investigating fraud, wa-;te, and mismanagement. Second, each 

agency is subject to evaluations by the Government Accountability Office, an independent nonpartisan 

agency whose fundamental purpose is to help improve the performance and accountability of the federal 

government.36 

33 /ptp: 1 :www.cow:!}JQYJenews&2...ltJ.:.2.[J !5/0-1.'02/jmnorgan-gjg-bailvut-record'i-remain-secret. htm. 34 http://blogs. 1'>-'Sj.com/economics,]O 1 5;0]l](), how-some-centra!-bank..'i-are-revie-..ved-arozmd-the-wor/&'. 15 f1J1Q;_//www.bankofengland.co,.,yk'about/pages 1

peovle1

court.@JJ;s. 36 f111Jr.ij.J::.!Vw.gao.gov/al]put/index.html 
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Office of the Inspector General (0/G). The Fed's Board of Governors has an O!G that reviews its 

procedures and operations, whereas the Federal Reserve Banks are private institutions that do not have 

any O!G. Moreover, the Board's OJG cannot conduct any investigation at a Federal Reserve Bank unless 

it obtains explicit prior permission from the president of that Federal Reserve Bank. Similarly, the 

Board's OIG cannot investigate any FOMC incident involving a specific Federal Reserve Bank without 

the specific prior consent of that Federal Reserve Bank's president. 

Such constraints on the authority of the Board's OTG authority arc inconsistent with the overarching goal 

of ensuring that the Federal Reserve functions as effectively as possible in serving the American people. 

By making the Fed fully public, the Board's OIG can assume responsibility for conducting independent 

reviews of all aspects of the entire Federal Reserve System--not just the Board of Governors. Moreover, 

as with all other major federal agencies, the Fed's Inspector General should be appointed by the President 

and confirmed by the Senate. 37 

Government Accountability Office (GAO). As noted above, the GAO is an independent nonpartisan 

agency that has a proven track record in improving the efficiency and effectiveness of federal goverrm1ent 

programs." In fact, over the past five years, the GAO has saved the taxpayers over $330 billion-a return 

of about $174 for every dollar spent running the GAO itself. 

Nevertheless, the GAO has only limited authority to examine the Fed's procedures and operations:'" 

For example, the GAO is cmTently prohibited from reviewing any Fed operations involving foreign 

central banks.'0 That prohibition seems particularly unfortunate in light of a recent instance in which the 

Federal Reserve Bank of New York inadvertently transmitted $&1 million to hackers who had broken into 

the computer system of the central bank of Bangladesh. A subsequent Reuters investigation found that the 

New York Fed was ''slow to react to waming signs" and "lacked a system for spotting potential fraud in 

real time, even though such systems were already in use elsewhere."41 Indeed, Congresswoman Caroline 

Maloney stated that the incident posed '·a threat to the confidence people could have in the central 

banking system." 

More generally, the GAO is currently prohibited from investigating any aspect of the Fed's monetary 

policy process, including the financial transactions conducted by the New York Fed on behalf of the 

FOMC. One purported rationale for that constraint is that the Fed's financial accounts are already 

subjected to annual audits by private-sector firms. However, those financial audits are solely focused on 

detecting specific evidence of fraudulent activity-a far narrower scope than the GAO's mission of 

identifying inefficiencies, operational risks, and potential improvements in policies or procedures that 

could be beneficial to the general public or save money for American taxpayers. Moreover, the private 

firms tasked with conducting Fed audits are by no means impeccable and certainly do not have a public 

track record like that of the GAO. For example, the accounting firm that conducted the most recent audit 

17 The GAO has studied this issue and concluded as follo\vs: "We believe that the differences in the appointment and removal 

processes between presidentia!fy appointed TGs and those appointed by their agency heads result in a clear difference in the 

level of independence of the IGs." {hllp:l/w·ww.gao.gov/ncw.ilems'd0952-lt.pdj) 38 http://www.gao. oov/products/GA0·/6-27 2T 39 GAO reports on specific Fed activities are posted at http://vv'\vwJCdcralrcservc.gov/newscvents/rcform audit g_ao.htm. 40 Under current law, GAO investigations of the Board of Governors and the Federal Reserve Banks '·may not include 

transactions for or with a foreign central bank, government of a foreign country, or non private international financing 

organi2:aticon.""(3l USC 7l4.b.!) 
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14 

of the Fed's books has been sued by Fannie Mae for alleged gross negligence, while the finn 

that previously audited the Fed has been ruled to have been negligent in a separate case.42 

Despite some common misperceptions, comprehensive GAO reviews of the Fed need not be a partisan 

issue. Indeed, over the past couple of decades proposals to "audit the Fed" have been advocated by 

members of Congress from both sides of the aisle 43 However, a significant pitfall of those proposals 

has been the prospect that such audits could become a means of political interference. Thus, in initiating 

full GAO reviews of the Fed. several specific provisions will be crucial: (I) Such reviews should be 

conducted on an annual basis, not be triggered by any congressional committee or member of Congress. 

(2) The GAO should freely determine the topics and focal points of each review. (3) The GAO should be 

prohibited from commenting on any specific monetary policy decision. With those provisions in place, 

comprehensive GAO reviews will significantly strengthen the Fed's effectiveness and its public 

accountability without impairing its operational independence to carry out its statutory mandate. 

C. Monetary Policy Reports 

In accordance with the Humphrey-Hawkins Act of 1978, the Federal Reserve provides semiannual 

monetary policy reports to Congress. That statute originally contained specific reporting requirements, 

but in 2000 those requirements were streamlined into a single broad requirement to provide "a discussion 

of the conduct £>lmonetmy policy and economic developments and prospects for the future, taking into 

account past and prospective developments in employment, unemployment, production, investment, 

real income, productivity, exchange rates. international trade and payments, and prices. " Indeed, 

many analysts have characterized the Fed's semiannual monetary policy reports as largely vacuous. 

Thus, in line with the practice of many other central banks, the Fed should begin producing quarterly 

monetary policy reports that explain the rationale for its monetary policy decisions and characterize 

the diversity of views among Fed oftlcials.44 In particular, each report should: 

Present quantitative assessments of the deviation of employment from its maximum level 

and the deviation of inflation from its mandate-consistent rate, and characterize the degree 

of uncertainty surrounding those assessments. 

Provide a baseline projection for the economy, including information about the factors that 

arc particularly relevant for specific sectors, regions, and demographic groups. 

IdentifY material risks to the current economic outlook and explain the Fed's plans for 

mitigating or responding to those risks. 

Discuss any economic models and benchmark rules that are used in setting the course of 

monetary policy. 

~ h1rv:/1www.washingtonpost.com/wp-dln'content/artic/e,2006/!2/f2/AR200612 J 20 1386.html: 

http.>Jwww.theglobeandmail.com!report-on-businessiindusrly-new.s,the-lmt·-pagelcourt-uphofds-ruling-on-deloittes-negligenceorer-!iv_ef}!/article 28078 7 84/ 43 GA()-;~dits w;~ a key plank of the Fed reform bill proposed in 1993 by Democratic Rep. Bent)' Gonzalez. 44 For example, quarterly monetary policy reports are produced by the Bank of Canada, the Bank of England, the Bank of 

Notway, and the Swiss National Bank. 
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15 

V. Conclusion 

In this paper, we have presented the case for a set of pragmatic and non patti san reforms that would 

strengthen the Federal Reserve's governance and enhance its operational independence to carry out its 

statutory mandate of fostering maximum employment and price stability. Moreover, these reforms would 

ensure that the Fed is a publicly accountable institution that takes a wide array of economic perspectives 

into account, thereby enriching the Fed's decision-making process while affirming the norm that those 

decisions should not be subject to political interference. 

At the heatt of the proposed reforms is a call to make the Fed a fully public institution whose decisionmakers are public officials selected through open and transparent processes. This begins with transferring 

ownership of the twelve regional Federal Reserve Banks away from commercial banks to the American 

people. By following procedures already in place for adjusting the shares of individual member banks, 

the process for carrying out this transition would be incredibly straightforward, and have no effect on the 

current value of U.S. government debt or the size of the Fed's balance sheet. 

Another key element in making the Fed fully public involves changing the process by which Federal 

Reserve Bank directors and presidents are appointed. In sharp contrast to the current process that is 

opaque, inbred and largely proforma, we propose a process requiring a higher degree of transparency in 

selection criteria, timeline, selection of candidates for president and board nominees, and extensive 

oppottunities for public input. To avoid potential conflicts of interest. we fm1her recommend that 

individuals affiliated with financial institutions overseen by the Fed should he prohibited from serving 

as directors. Additionally, establishing a single non-renewable 7-year term of office for every Fed 

policymaker-including the Chair, the Vice Chairs, the other members of the Board of Governors, 

and the presidents of the Federal Reserve Banks-would strengthen the Fed's operational independence 

and accountability. 

There are clear and measurable bcnetits to these proposed reforms. Making the Fed fully public would 

generate a fiscal benefit for American taxpayers of at least $300 million per year. These additional 

savings would come from larger transfers of net income from the Fed to the U.S. Treasury as a result of 

the Fed no longer having to pay dividends to commercial hanks. In addition to this fiscal benefit, the 

reforms we've outlined also provide greater capacity for the Fed to more fully represent and serve the best 

interests of the American people when making monetary policy decisions. As America's central bank, the 

Fed's monetary policy decisions affect the everyday lives of practically every American family, and have 

even greater consequences for specific demographic groups. Bringing the appointment process out of the 

shadows and expanding opportunities for public input in the appointment of Fed officials responsible for 

making monetary policy greatly increases the potential for assembling a more diverse and inclusive body 

of decision makers. More diversity, in terms of race, ethnicity, gender, educational background and 

professional experience, would enhance the Fed's ability to comprehensively and accurately assess the 

strength of the economy in advance of making monetary policy decisions. 

Proposals to make the Fed fully public have been debated since the 1930s. Failure to make that transition 

has resulted in a Federal Reserve governance structure that is outdated and inadequate for ensuring that 

the Fed serves the public interest. Moreover, the Fed's private ownership by commercial banks is now out 

of step with practically every other major central bank around the world. Incremental amendments to the 

Federal Reserve Act at various points in time have routinely failed to overcome the hindrances of private 
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16 

ownership, or to transform the leadership of the Federal Reserve Banks beyond the status quo, which is 

overwhelmingly white, male and insular- dominated almost exclusively by long-time Fed insiders and 

individuals with a financial background. 

Overcoming these deficiencies and bringing about lasting change within the Federal Reserve requires 

Congressional action to make the Fed a fully public institution. Pragmatic reforms that appeal to the 

nonpartisan principles of good governance, transparency and accountability are the best way to ensure 

that the necessary Congressional action is taken. While the reforms outlined in this paper are by no means 

the only options on the table, they undoubtedly meet fhose standards. 
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journal of Economic Dynamics & Control 

journal homepage: www.elsevier.com/!ocat~!jedc 

The design and communication of systematic monetary 

policy strategies"'" 

Andrew T. Levin 

Research Department at the lntemational Monetary Fund, Uniled States 

ARTICLE INFO 

Artide hi.~toty: 

Received 13 August 2014 

Received in n.•vised form 

5 September 2014 

E.32: 

E52 

E58 

J21 

Keywords: 

Centra! Bank independ"nce 

Inflation targeting 

Simple monetary policy rules 

1. Introduction 

ABSTRACT 

The efficacy of central bank communications is inextricably linked to the characteristics of 

the monetary policy framework. Therefore, this paper presents a set of fundamental 

principles regarding the joint design of monetaty policy strategy and communications. 

The practical implications of these principles are illustrated by considering a number of 

significant policy challenges faced by central banks in the advanced economies. 

Published by Elsevier B.V. 

Over the past two decades, central banks around the world have made tremendous strides in clarifying their monetary 

policy communications. Indeed, while many other aspects of monetary policymaking remain controversial, economists have 

reached a broad consensus regarding the strong rationale for clarity about the central bank's policy framework, that is. its 

longer-run goals and strategy, its assessments of the economic outlook, and its judgments about the appropriate path of 

policy. 1 In large part, the breadth of this consensus is a reflection of two distinct benefits: 

• Clarity about the monetary policy framework bolsters the effectiveness of the monetary transmission mechanism by 

enhancing the private sector's understanding of how the stance of policy is likely to evolve in response to changes in 

economic and financial conditions. 

'~This paper was prepared for the Hoover Institution conference on ''Frameworks for Central Banking in the Next CenturyH to be held at Stanford 

Uniwrsiry on M.Jy 29-30, 2014. The author appreciates many invaluable conversations with George Akerlof, Ali Alichi, Ravi Balakrishnan. Andrew Berg. 

Olivier Blanchard, Danny B!anchflower, Dennis Botman, Charles Calomiris, Nigel Chalk, Luisa Charry, Stephan Danninger, jorg Decressin, Christopher ErC('£", 

josh Felman, Emilio Fernandez, Thomas Helbling, Dougl,ls Laxton, Lusine Lusinyan, Tommaso Mancini, jean-Marc Natal, Andrea PescaLori, Adam Posen, 

Markus Rodlauer, juan Sole, Lars Svens.'ion, and john Taylor. Nonetheless, the views expressed here are solely those of the author and do not necessarily 

reflect the views of the International Monetary Fund or of any other person or inStitution. 1 See Bllndfr <::t ,1i :2009; and YeliPn :"J.Ol .3). 
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A. I Levin I journal of Economic Dynamics & Contro/49 (2014) 52-69 53 

• Transparency about monetary policy is essential for maintaining the central bank's operational independence in a context 

of public accountability, thereby enabling its policy decisions to remain insulated from short-term political pressures. 

Economic and financial developments in recent years have broadly confirmed the importance of clear central bank 

communications and in many instances have also underscored the scope for significant further improvements. 

In contemplating these issues, it is essential to recognize that the efficacy of central bank communications is inextricably 

linked to the characteristics of the monetary policy framework. Therefore, this paper presents a set of fundamental 

principles regarding the joint design of monetary policy strategy and communications. These principles are framed in terms 

that are likely to be relevant for a wide array of central banks, including those of emerging markets and low-income 

countries. For the sake of brevity, however, the practicJI implications of these principles are generaHy illustrated using 

current policy challenges facing central banks in advanced economies. It should also be emphasized that such examples are 

solely for illustrative purposes and not intended to provide any definitive policy recommendations. 

ln particular, simple monetary policy rules can serve as valuable benchmarks for central banks in the decision-making 

process and in explaining those policy decisions to the public.z Of course, it would be inadvisable for policymakers to 

mechanically follow the prescriptions of a rule whose specification has been permanently fixed. However, in circumstances 

where policymakers judge that the stance of policy should deviate temporarily from the path prescribed by the policy rule. 

the rationale for doing so should be clearly explained to the public. Moreover, the central bank should maintain a systematic 

procedure for considering potential adjustments to the specification of its policy rule, recognizing that minor technical 

adjustments might occasionally be warranted whereas the fundamental characteristics would not be modified unless there 

were compelling reasons for doing so. 

The remainder of the paper is organized as follows: Section 2 lays out several broad principles regarding monetary policy 

strategy and communications. Section 3 considers the framing of the central bank's inflation objective. Section 4 discusses 

the central bank's assessments of resource slack. Section 5 analyzes the use of simple policy rules as benchmarks. Section 6 

considers the merits and limitations of specific communication tools. Section 7 concludes. 

2. Some general principles 

Central bank communications contribute to economic prosperity by facilitating well-informed decisions of households 

and businesses and by reducing economic and financial uncertainties. Clear communications also enhance the effectiveness 

of the moneta1y transmission mechanism by helping financial market participants and the general public understands how 

the stance of policy is likely to evolve in response to changes in economic and financial conditions. In recent decades, 

economists have also arrived at a broad consensus regarding the importance of insulating monetary policy decisions from 

short-term political pressures. However, the central bank's operational independence is only sustainable if the government 

provides a clear legal mandate regarding its policy objectives and instruments and then holds the central bank accountable 

over time for fulfilling that mandate. Consequently, enhancing the transparency of the central bank's policy framework and 

communicating clearly about the rationale for its specific policy decisions facilitate accountability to the general public and 

thereby reinforce the central bank's operational independence.1 

"'* Provide regular communications regarding the central bank's assessments of the balance of risks to the economic 

outlook and contingency plan..-;; for mitigating and addressing such risks. 

Forecasters at many central banks and in the private sector have tended to focus on providing precise assessments of the 

modal outlook rather than on gauging the evolution of the balance of risks. Scenario analysis is a valuable tool for examining 

key risks and formulating contingency plans aimed at mitigating such risks. In effect, it may be beneficial for central banks 

to conduct and publish stress tests for monetary policy, analogous to the stress testing that is becoming standard practice for 

private financial institutions. 

* Communicate clearly about the central bank's plans for adjusting the specific instruments that will be used in 

implementing its policy strategy over time. 

The central bank may be able to deploy a number of distinct monetary policy instruments. depending on its legal mandate 

and on the characteristics of the domestic financial system. For example, such tools may include direct lending to financial 

institutions, payment of interest on reseiVes. and transactions in publicly traded securities or foreign exchange. Thus, clarity 

about the central bank's monetary policy framework necessarily involves transparency about its choice of instruments, including 

its assessments of their efficacy, costs, and risks. TI1ere are also substantial benefits of clarifying the central bank's judgments 

reg.:m1ing the appropriate path of policy as well as the conditions that could warrant significant adjustments to that path.4 

St-e faylnr ,md William~ ;_2{)10) for further analysis and dismssion. 3 Indeed. in his remarks at last December's official commemoration of the Federal Reserve's centennial, then-Chairman Brm;mkf.' \2011) stated: 

"Ultimately, however, the most important reason for transp.1rency and dear communication is to ensure the accountability of our independent 

institution to the American people .md their elected representatives." See also Bern<lnke (20071 and ~2014). 

4 See Gwkdynal' et ,1L t2005), Swan~on and WJ!lJams 12014\ Slem \2014i, and Yellen z2011. 2014;. 
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54 A.T. Levin j journal of Economic Dynamics & Control 49 (2014) 52-69 

:::::::} Foster and encourage a diversity of viewpoints in the process of fonnulating the central bank's policy decisions and 

communications. 

Historically, the institutional culture of central banks has tended to be quite conservative, with a strong inclination towards presenting a unified front in all public communications. However, effective risk management and 

contingency planning require "outside-the-box" thinking and creative problem-solving. These considerations underscore 

the institutional benefits of ensuring that both policymakers and staff represent a diverse set of backgrounds and 

perspectives. 

3. The inflation objective 

::::::} Establish a numerical inflation objective that will serve as a fundamental benchmark for monetmy policy strategy and 

communications. 

In the absence of an explicit inflation objective. the central bank may be particularly susceptible to short-term political 

pressures that lead to gradual upward drift in inflation expectations.5 Conversely, empirical analysis has demonstrated that 

a transparent and credible inflation objective has significant effects in keeping inflation expectations firmly anchored, which 

in turn contributes to the stability of actual inflation.'1 Moreover. specifying a numerical inflation objective provides the 

central bank with greater flexibility to promote macroeconomic and financial stability.7 

The process of initiating or revising the inflation objective depends on the central bank's institutional setting. 1n 

particular. the specification of this objective may be legislated in the central bank's charter or determined by periodic 

consultations with government authorities. Alternatively, the central bank itself may determine the inflation objective that 

is judged to be most consistent with its legal mandate. For example, in 2003 the Governing Council of the European Central 

Bank (ECB) established a quantitative definition of price stability-its mandate under the Maastricht Treaty-as keeping 

consumer price inflation "below but close to 2 percent over the medium term." More recently, the Federal Open Market 

Committee (FOMC) and the Bank of Japan (BOJ) have each established an inflation goal of 2 percent 

3.1. Specification 

,_,. The inflation objective should be defined in terms of a broad measure of consumer prices: that definition should only be 

adjusted for technical reasons. 

In the advanced economies. the inflation goal has generally been defined in terms of a broad measure of consumer prices. 

such ~s the consumer price index (CPT) or the price index for personal consumption expenditures (PCE). Such measures of 

inflation may also fluctuate in response to fiscal policy adjustments. such as a revision in government-administered prices or 

indirect tax rates. However. the central bank can readily make note of those factors in its monetary policy communications; 

indeed, the Bank of Japan (BOJ) has regularly done so in explaining the implications of recent and prospective value-added 

tax (VAT) rate hikes. 

It should be noted that significant communication challenges may arise if the inflation goal is defined in terms of a price 

index that responds directly to movements in the level of short-term interest rates. For example. a monetary policy 

tightening aimed at restraining inflation pressures may nonetheless induce an near-te1m upward shift in such an inflation 

measure. In light of such concerns, the Bank of England's inflation target was initially defined in terms of the retail price 

index excluding mortgage payments (RPIX) rather than the overall retail price index (RPI). A few years later, tl1e Bank of 

England's inflation target was redefined in terms of the CPJ, but that redefinition was clearly explained as a technical 

adjustment and hence did not undermine the credibility of the monetaty policy framework. 8 

:;:;:} The nume1ical value for the inflation objective should be re-examined periodically but should only be modified for 

compelling economic reasons. 

To serve as an effective nominaJ anchor, the inflation objective must be transparent and credible~ that is, the private 

sector must have a reasonable degree of confidence that this objective will be sustained over time and that the central bank 

will take actions as warranted to fulfill that objective. Indeed. in analyzing the early experiences of several inflationtargeting central banks, Bernankc et aL {l999) found that the private sectors inflation expectations tended to move only 

gradually in the wake of the initial announcement of the inflation objective. Moreover. such patterns do not necessarily 

reflect sluggish information flows or irrationality; rather, the evidence indicates that even professional forecasters tend to 

5 See Levin 6 See lcvm N al, (2010), and ,,L (2011 ). 7 The Federal Open Market Committee's statement on longer-run go.als and policy strategy (W\K, 2014) indicates: "Communicating this inflation goal 

clearly to the public helps keep longer-term inflation expe<:tations firmly anchored, thereby fostering price stability and moderate long-term interest rates 

and enhancing the Committee's ability to promote maximum employment in the face of significant economic disturbances." 8 See Kinp; (2004) and Curkaynak eta!. (2010). 
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A.T. Levin I journal of Economic Dynamics b' Conrrol 49 (2014) 52,59 55 

199<1 1994 2{102 2006 2010 2014 

Fig. 1. The Evolution of Longer-Run Inflation Expectations in Three Adv.lnced Economies. Source; Consensus Forecast longer-run surveys of CP! in!lalion 

projections 6 to 10 years ahead, published semiannually in Apnl dnd October. Covyrig.ht (c) Consemus Economics Inc. 

take a wait-and-see approach in assessing the extent to which a significant institutional change is likely to be durable over 

time.·" 

The numerical value of the inflation objective is appropriately determined in light of assessments of the relative costs of 

inflation, the extent of downward nominal wage rigidity, and the costs and risks associated with the zero lower bound on 

nominal interest rates. Such assessments might well evolve over time as a result of new data and empirical analysis, and 

hence the specific value of the inflation objective should not be viewed as having been set permanently in stone. On the 

other hand, frequent tinkering with the specification of this objective incurs the risk of undermining its clarity as well as its 

credibility. Hi Consequently, the specification of the inflation objective should be revisited on a periodic but relatively 

infrequent basis~perhaps once eveiy five or 10 years~ in the context of a comprehensive review of the central bank's policy 

framework. Moreover, such reviews must be systematic and transparent to ensure that any modification of the inflation goal 

would only occur as a consequence of compelling economic reasons rather than short-term political pressures. 

To illustrate the foregoing principles, it is helpful to consider the evolution of longer-run inflation expectations in three 

advanced economies. as depicted in Fig. 1. 

Canada: In early 1991, the Canadian government and the Bank of Canada agreed on a policy framework with a mediumterm inflation target of 2 percent for the total consumer price index (CPI). Initially, that target does not appear to have been 

fully credible: as of spring 1992, professional forecasters still anticipated that CPI inflation would settle at around 3 percent 

over the longer run. Over time, however, inflation expectations moved into line with the target, facilitated by the Bank of 

Canada's actions and communications and underpinned by the breadth of public support for its policy framework. Indeed, 

smvey evidence and financial market data indicate that inflation expectations in Canada have remained firmly anchored 

since the late 1990s. 11 Moreover, the monetary policy framework has been reviewed regularly at five-year intervals, but each 

of those reviews has concluded that the existing policy framework continued to be workable and appropriate; cf. Carney 

(2011). 

United States: Longer-term U.S. inflation expectations drifted steadily downward during the 1990s~a period in which the 

Federal Reserve did not have an explicit inflation objective but pursued a course of policy that has been characterized as 

"opportunistic disintlation. 11 That course of policy effectively ended in mid-2003, when the Federal Open Market Committee 

(FOMC) indicated that a substantial further decline in inflation would be unwelcome. Consequently, professional forecasters 

longer-term outlook for U.S. consumer inflation levelled off at around 2 percent, although empirical analysis subsequently 

indicated that inflation expectations were still not as firmly anchored as in a number of other economies that had 

established an explicit numerical inflation objective. In january 2012, the FOMC established a longer-term inflation goal of 

2 percent, as measured by the price index for total personal consumption expenditures (PCE), and has reaffirmed that 

inflation goal at each of its annual organization meetings since then. 15 

japan: During the 1990s, the Bank of japan (BOJ) indicated that it was aiming at modestly positive levels for published 

measures of inflation. thereby keeping the true underlying rate of inflation close to zero. The Consensus Economics longer-run 

10 J).:!'nutc-r ct 111. analyzed data three emerging-market economics and found that inflation expectations were somewhat less firmly 

anchored in Brazil (where inflation target is speofied on a year-to-year basb) compared with Chile and Mexico (e.Kh of which has a fixed target for 

inflation). 11 The Consensus Economics survey results indicate that professional forecasters longer-run outlook for Canadian inflation has stayed very close to the 

2 percent target throughout the past 15 years. Moreover, Gmkdyt;dk n <1!. (2006 1 analyzed Canadi<m daily data on forward inflation compensation that is. 

the difference between forward rates on nomina! and inflation-linked bonds and found that tar~forward inflation compensation did not respond 

significantly to either Canadian or U.S. macroeconomiC news. 12 See !l:kyn (1~J%l.md Orph,:;wdc; .1nd 13 !t should be noted that rlg-. 1 longer-run outlook for U.S. CPI inflation-the measure used in Consensus Forecast surveys. 

The Federal Reserve Bank of Philade!phias quarterly Survey of Professional Forecasters (SPF) elicits projenions for both the CPI and the r'CE price index. In 

the May 2014 survey, the SPF's median projection for the 10-year average U.S. PCE inflation rate was exactlY 2 percent, while the conesponding projection 

for U.S. CPI inflation was a notch higher at 2 1/4 percent. virtually identical to the outlook in the April 2014 Consensus survey. 
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56 A. I levin 1 journal of Economic Dynamics [J' Contro/49 (2014) 52~69 

outlook for japanese CPI inflation declined gradually during the 1990s. it remained at around 1 percent through the 

subsequent decade even as heddline inflation was generally running below zero.l4Jn March 2013, the BOJ announced a strong 

commitment to taking the requisite quantitative and qualitative policy measures in order to achieve its 2 percent inflation 

goal. The BOj's actions and communications evidently succeeded in bolstering the credibility of its infl.ation goal: as of April 

2014, the longer-run Consensus outlook for Japanese CPI inflation stood at 1.7 percent. up from 1.1 percent a year earlier and 

higher than any previous reading since the mid-1990s. 

3.2. Time frame 

"'* The central bank must clearly convey its assessments of the time frame over which inflation is projected to converge to 

its objective and the policy actions that are likely to be warranted in fostering that conve1gence process. 

Generally speaking, the framing of any goal may be practically meaningless without some sort of concrete plan for 

achieving that goal within a reasonable time frame. Thus. to ensure that its inflation objective serves as an effective nominal 

anchor, the central bank must dearly communicate its strategy for bringing inflation back to the objective, including the 

anticipated time frame tOr the convergence process as well as the policy actions that are likely to be warranted. 

The appropriate time frame for closing the inflation gap-that is, the deviation of actual inflation from its objectiveevidently depends on conjunctural conditions. For example, if a transitory commodity price shock induces a spike in 

consumer price inflation, policymakers may reasonably anticipate that inflation is likely to revert to its objective fairly 

quickly even in the absence of any policy actions. Conversely, an ongoing acceleration in commodity prices may exert 

persistent upward pressure on inflation. and a significant monetary policy tightening might indeed be warranted to offset 

such pressures and bring the inflation rate back to its objective. Indeed, in the absence of clear communications about the 

central bank's policy strategy, longer-run inflation expectations could become dislodged and exacerbate the upward 

pressure on actual inflation. 

Inflation gaps can also arise from shifts in aggregate demand that may result from changes in fiscal policy, external 

demand, or credit market frictions. During "normal" times. the central bank can take prompt action to offset such shifts, 

thereby stabilizing resource utilization and keeping the inflation rate close to its objective. In contrast, when faced with a 

large and protracted decline in aggregate demand, monetary policy can become constrained by the zero lower bound on 

nominal interest rates, and hence the shortfall in aggregate demand may exert persistent downward pressure on the 

inflation rate.L~ Under such circumstances, the rationale for clear monetary policy communications becomes even more 

compelling: 

To illustrate some practical implications of this principle, we briefly consider recent developments and prospects for 

inflation in the United States and the euro area. 

United States: U.S. inflation plummeted during the Great Recession and remained subdued during the early stages of the 

economic recovery. Indeed, Federal Reserve officials flagged the risk of further disinflation or deflation as a key rationale for 

launching a second round of large-scale asset purchases (commonly known as QE2) in late 2010.16 In the first half of 2011, 

headline inflation moved sharply upwards in the wake of surging global prices of energy and other commodities, and 

measures of core inflation also headed upward. reflecting pass-through of higher input prices as well as the effects of 

supply-chain disruptions in the aftermath of a tragic earthquake and tsunami in japan. At that juncture, the FOMC clearly 

indicated its judgment that those developments were largely transitory and hence that consumer inflation would "subside 

to levels at or below those consistent with the Committee's dual mandate as the effects of past energy and other commodity 

price increases dissipate." (FOMC. 2011) 

As shown in FiR. 2, that expectation proved to be well-founded. The four-quarter average rate of PCE inflation peaked at 

around 2 3}4 percent in 201"1 :Q3 and then headed steadily downward toward a level of about 1 percent. As of early spring 

2014, FOMC participants and professional forecasters generally expected that PCE inflation would head gradually upward 

toward the FOMC's 2 percent inflation goal. Indeed. at that juncture the FOMC made note of the risk that inflation could 

remain flat or decline further over coming quarters. 17 

Euro Area: As noted above, the ECB's policy strategy since 2003 has been explicitly intended to maintain euro area CPI 

inflation "below but close to 2 percent over the medium run." The ECB President subsequently defined this time frame very 

specifically: "The medium term for a central bank is a period of 18 months to two years." (Trki"H~t, 2008). Actual inflation has 

exhibited substantial fluctuations in recent years. dropping close to zero in the wake of the global financial crisis and then 

14 In 2006 the nornirtal anchor was framed more specifically in terms ofyNHo-ye<tr changes in the CPJ, and policy board ml"rnbers' assessmems of rhe 

appropriate value for the inflation goal had a midpoint of 1 percent. ln early 2012, lhe BOJ specified a numerical inflation goal of 1 perc<.>nt for the time 

being" and a year later the BOJ rev1sed its inflation goal upward to 2 percent. 15 1\·l.lllw.,.on N <ll. inflation developments in the advanced economies in the wake- of rhe global finandal crisis. 16 See !krnankc ·:2010; and (2011 }. 17 During the first half of2014. each FOMC meeting .<.tatement indicated that 'The Committee recognizes that inflation persistently below its 2 percent 

objective could pose risks to economic performance. and lt is monitoring inflation developments carefully for evidence that inflation will move back toward 

its objective over the medtum term. n 
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A. I Levin I )oumal of EconOmiC Dynamics & (ontTo149 {2014) 52-69 57 

Z1HO lOll ZOlZ ZOI3 2014 2015 Z016 

Fig.. 2. The U.S. inflation outlook. Note: In this figure, actual U.S. inflation (solid line) is measured by the four-quarter average fhange in the PCE price index. 

The FOMC's inflation outlook (long-dashed line) is represented by taking the midpoint of the centra! tendency of the PCE inflation projections of individual 

Committee participants. as published in the March 2014 Summaty of Economic ProjectiOns (SEP). The private sector's inflation outlook (short-dashed line) 

is represented by the projenions for PCE inflation published in the May 2014 edition of the Federal Reserve Bank of Philadelphia's Smvey of Professional 

Forecasters (SPF). The post-2007 trend (dot-dashed line) is estimated by ordinary least squares regression using quarterly data for the period 2007:Q1 to 

2014:Q1. 

2010 2012 2014 ;l(ll6 2018 2020 

Fig. 3. The inflation outlook for the Euro area. Source: Consensus forecast longer-run St!rveys of CPl infl.ltion projections 6-10 years ahea.d. published 

semi<mnually in April and October. Copyright (c) Consensus F.cmmmics Inc. 

rising above 2 1/2 percent following the global surge in commodity prices. In the face of those developments, however. the 

ECB succeeded in keeping longer-run inflation expectations anchored at around 2 percent. 13 

As shown in Fig. 3. the inflation outlook for the euro area deteriorated markedly over the course of 2013 and early 2014. 1

:·) 

According to the Consensus Economics longer-run survey published in April 2014, forecasters expected that euro areJ 

inflation would rise only gradually over coming years before eventually converging to the ECB's inflation objective towards 

the end of the decade-a far longer convergence horizon than would be implied by a "medium run" time frame. Moreover, 

the-re were notable downside risks to that outlook: In the ECB's May 2014 survey of professional forecasters. respondents 

assigned a 30 percent probability to outcomes in which the inflation rate in 2015 would remain below one percent. In light 

of those risks. ECB officials indicated that they were prepared to take further policy actions to foster a more satisfactory 

inflation outlook and to ensure that inflation expectations would remain firmly anchored. 

3.3. Financial stability considerations 

=> The central bank should ensure that financial stability considerations do not undermine the public's confidence in its 

nominal anchor. 

The global financial crisis spurred the recognition that price stability and macroeconomic stability are inextricably linked 

to the stability of the financial system. Moreover. while macroprudential supervision and regulation should serve as the first 

line of defense in averting financial crises, there is a growing consensus that monetary policy adjustments may also be 

warranted under some circumstances. While a full discussion of the implications for the design of monetary policy strategy 

and communications would go well beyond the scope of this paper. one key aspect bears emphasis at this juncture.?0 

18 See BH·dl(·y d ,1!. [20!1~ and G.1l;m ct ,1J. :2011:. 19 The contours of the inflation outlook in the ECB's quarterly survey of professional forecasters (available at http: ;ww'<v.ecb.turopa.eu;\rats;'prlce;, 

mdiciforcc.a\t) a!'e very similar to the Consensus survey results shown in Fig. 3. 2

° For further analysis and discussion. see Sven~\D,1 : 20nl and Alicbi <'1 al. (2014 ~. 
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58 A. I tevin 1 journal of Economic Dynamics & Conirol 49 (2014) 52-69 

Nonvay 

Percent 

3.00,----r,--=======n 

--- Inflation T argct 

2.75 

2.50 

2.25 

2.00 

1.75 

Sweden 

Percent 

2.6 -,----r, ==========n 

--- Inflation Target 

2.4 

2.2 

2.0 

1.8 

1.6 

1.4 -h--rrrrrrl-r-r-r-rTTrn'TT-rrrrrn-,-,-,..,-..,.,J 

1998 2002 2006 2010 2014 

Fig. 4. The evolution of longer-run inflation expectations in two Scandinavian economies. Note: Each panel depicts the centra! bank's iofl<~tion target 

(dashed line) and the evolution of longer-run inflation expectations (solid line), as measured by a moving average of the l,ltest two semiannual Consensus 

forecast surveys ofCP! inflation projections 6-10 years ahead. Copyright (c) Consens.us Economics Joe. 

In particular, it seems to be essential to ensure that financial stability concerns do not undermine the public's confidence 

in the central bank's nomina! anchor. Indeed. keeping longer-term inflation expectations firmly anchored is almost surely a 

crucial element in fostering the safety and soundness of the financial system. Conversely, a policy strategy that allows 

inflation expectations to drift over time seems likely to be counterproductive for financial stability as well as price stability. 

Fig. 4 points to the potential relevance of this issue for two Scandinavian economies. The Sveriges Riksbank's inflation 

target of 2 percent was established in 1993, and by the late 1990s longer-run inflation expectations were welt-anchored at 

that target. Norges Bank's inflation target of 2.5 percent was established in 2001. and over the subsequent decade it 

succeeded in keeping longer-run inflation expectations close to that target. More re-cently. however, both of these centra! 

banks maintained a relatively tight stance of monetary policy aimed at mitigating emerging financial imbalances, even as 

inflation dropped persistently below target in each economy. Consequently, longer-run inflation expectations--at least as 

measured by Consensus Economics surveys-began drifting downward noticeably. 

The inciden-ce of disagreement among forecasters tends to be highly correlated with the degree of uncertainty about the 

economic outlook: cf. D'Amico d!Hl Orpha11ides {2008). Consequently, measures of cross-sectional dispersion can also serve 

as useful indicators of the extent to which longer-run inflation expectations are firmly anchored.21 for example, the TNS Sifo 

Prospera survey (which is conducted on behalf of the Sveriges Riksbank) indicates that the degree of dispersion regarding 

the Swedish inflation outlook widened notably over the past several years. ln particular, the cross-sectional standard 

deviation of 5-year-ahead inOation projections increased from 0.30 percent in january 2011 to 052 percent in july 2014. 

Over the same period, the mean forecast in the TNS Sifo Prospera survey declined about 0.3 percentage points to a level of 

about 1.8 percent?.:; Moreover. since the extent of dispersion is directly linked to the degree of sampling uncertainty 

associated with any specific survey, these results do not appear to be significantly different from those obtained from the 

Consensus Economics longer-run surveys. 

4. Assessments of resource slack 

"'* The central bank should regularly communicate its assessments of resource slack and the degree of uncertainty 

sun·ounding those assessments. 

One of the cornerstones of modern macroeconomics is that every economy has a balanced-growth path that is consistent 

with keeping intlation stable at its desired rate. With that conceptual framework in mind, there are two compelling reasons 

for assessing the magnitude of resource slack-that is, the level of economic activity relative to the balanced-growth pathand incorporating such assessments into the central bank's monetary polit-y strategy and communications. First, shortfalls in 

21 See Curkaynah N di. (?:010: and 22 The survey methodology and 

et <!I. ':2011.1. 

results are available at http://WlNW.prosperasejrepart.sjinflation~expeaations. 
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A. I Levin j journal of Economic Dynamics & Control 49 (2014) 52·-69 59 

aggregate income and employment have direct human costs. because households experience a lower level of economic 

wellbeing. Second, rates of resource utilization influence the setting of wages and prices. and hence persistent resource slack 

tends to exert downward pressure on inflation; conversely, persistently elevated rates of utilization tends to induce upward 

pressure on inflation. Consequently, the monetary policy goals of macroeconomic stability and price stability are generallythough not always-complementary. 

Of course, the contours of the balanced-growth path cannot be directly measured, so its characteristics must be inferred 

using statistical analysis of observable data. Moreover, such estimates are necessarily uncertain and subject to revision, and 

the extent of that uncertainty may be highly relevant in determining the course of monetary policy. These considerations 

underscore the benefits of regular communication of the central bank's assessments of resource slack as well as the degree 

of uncertainty surrounding those assessments. 

To illustrate these issues. the remainder of this section focuses on challenges in gauging the magnitude of labor market 

slack-an issue that is of particular relevance for U.S. and U.K. policymakers at the current juncture. 

4.1. Deviations from Okun~ law 

In his classic work, Okun (1962) documented a set of empirical comovements between real output and the 

unemployment rate-often referred to as Okun's Law-that have proven to be remarkably robust over time and across a 

wide array of countries.23 For example, the following version of Okun's Law is estimated using annual U.S. data from 1980 to 

2007: 

Ll.u, ,~ 1.26- 0.431\.y, (0 16) (0.04) 

{1) 

where Ll.u, denotes the change in the unemployment rate (Q4/Q4), Ll.y, denotes the growth rate of real GDP (Q4/Q4), and 

the standard error of each regression coefficient is shown in parentheses. This equation has a remarkably good fit 

(R2 =0.79), and the residuals exhibit no serial correlation at all (DW=1.89). 

In effect, Okun's Law indicates that the unemployment rate will tend to dedine when the growth of actual GOP exceeds 

its potential growth rate, and conversely, that unemployment will tend to show little or no improvement when real GOP 

growth is roughly in line with its longer-run normal rate. As shown in fig. 5, however, the recent evolution of the 

U.S. economic outlook does not seem to have been consistent with that pattern. 

As shown in the upper panel of the figure, real GDP growth from 2010 through early 2014 consistently underperformed 

relative to the FOMC's economic outlook;l4 For example. in November 2010 the FOMC indicated that the economic recovery 

had been "disappointingly slow" and launched its second round of large-scale asset purchases (QE2); at that time FOMC 

participants generally expected that by 2012 the pace of real GDP growth (Q4/Q4) would pick up to about 4 percent.ln fact, 

however. output growth during 2011-2012 only averaged about 2 percent-not even reaching most participants' 

assessments of its longer-run normal rate. Consequently, in September 2012 the FOMC initiated a third round of asset 

purchases (QE3), with the expectation that output growth would subsequently pick up to around 3 1/2 percent." 

Unfortunately, the economy underperformed yet again during 2013, with GOP growing notably slower than Committee 

participants' assessments of its potential growth rate (which had been revised downward about a half percentage point 

relative to their assessments three years earlier). 

In light of Okun's Law, one might have expected that the persistent underperformance in economic growth would have 

been associated with relatively little improvement in the unemployment rate. In fact, however, as shown in the lower panel, 

the decline in unemployment over that timefr.:~me was much steeper than the FOMC anticipated.:u; For example, the FOMC's 

june 2011 meeting statement conveyed the expectation that unemployment would "resume its gradual decline," and the 

statement issued in November 2011 indicated that the Committee expected that unemployment would "decline only 

gradually towards levels judged to be consistent with its mandate." At that FOMC meeting, participants generally projected 

that the unemployment rate would be close to 8 percent as of 2013:Q4. In fact, however. the unemployment rate 

plummeted to around 6 3/4 percent by the end of2013 and to around 6 percent by mid-2014-only slightly higher than the 

upper end of the central tendency of FOMC participants' assessments of its longer-run normal rate. 

21 See recent studies by f{a!Je-t ,JJ. (20Hl .and Llaly ('t <1!. 24 !n 2007 the FOMC initiated the quarterly publication of its Summary of Economic Projections (SEP). which reports the central tendency and range of 

Committee participants' projections for GOP growth. unemployment, and inflation. (The phrase "Committee pi!rticipants" refers to all of the members of 

the Board of Governors and presidents of the Federal ReseJVe Banks.) ln 2009 the FOMC further enhanced its communications by reporting on participants' 

estimates of the longer-run norma! rates to which those variables would converge over time in the absence of further shocks. In effect, the SEP's longer-run 

projections convey p.:trticip.ants' assessments of the characteristics of the balanced-growth path, that is, the potential GDP growth rate and the natural raie of 

unemployment(often referred to as the NAIRU). 

~:s At that meeting, the FOMC also announced its expectation that a highly accommodative stance of policy would likely remain warranted ··for a 

considerable penod as the economic recovery strengthens" and that Hfroff from the ZLB was not likely to be warranted ·•ar least until mid-2015." 26 From November 2010 to April 2011. FOMC meeting st.:~tements projected "a gradual rE;>tum to higher levels of resource utilization." The june 2012 

FOMC statement projected that the unemployment rate would "resume its gradual decline'", while subsequent FOMC statements projected that the 

unemployment rate would ··decline only gradually" (August 2011 to january 2012), wdedine gradually·• (March and April 2012), ··decline only slowly'· (June 

and August 2012). and ~gradually decline" (January 2013 to january 2014). 
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60 AI Levm j journal of Economic Dynamics & Control 49 (2014) 52-69 

r~rceot 

2010 

Percent 

10 

2011 

Real GDP Grvwtb 

I

I ·'"••IGrow<h -- ~""· 211Hl Outlook 

---&p. 21112 Outlook 

--- Mar. 21114 Outlook 

C=:J Lunger-Run Normal Rat;:c 

2012 2013 201-4 2015 2016 

Vnemph.oyment Rate 

Actual Unemployment 

--Nt>v. 21Hl Outll)(lk 

9 ~---- ===-~:~:i:!!6:::::~ ---- --- Recent Trend ...... ....._ c::ll-'.lU(:I'r-Run N!>nnai!Ute 

-~-::.::.:_ 

::..._-.. ---.. ._::-- ' ----- 2011 2012 2013 2014 2015 2016 

Fig. 5. The evolution of the U.S. economic outlook. Note: The upper panel depicts the actual path of U.S. real GOP growth (solid line) from 2010:Ql through 

2014:Qt along With the midpoint of the central tendency ofFOMC partlnpants' projections for the trajectory ofGDP growth (Q4/Q4) as of November 2010 

(dashed), September 2012 (dot-dashed), and March 2014 (dot-dot--dashed). The !ower panel depict<> th<> actual path of the U.S. unemployment rate {solid 

line) from january 2011 through April 2014; the midpoint of the central tendency ofFOMC participants' projections for the path of the unt'mp!oyment rate 

(Q4 average) as of November 2011 (long-dashed), March 2013 (dot--dashed), and March 2014 (dot-dot-dashed); and the linear trend based on the latest 

12 months of unemployment readings. !n each panel, the shaded area denotes the evolution of tht' ('entral tenden'y of FOMC participants' <~.ssessme-nts of 

the longer-run normal rate; those cerHral tendencies are Slmply extended from March 2014 through the end of 2016 for illustrative purposes. 

These departures from Okun's Law can be gauged in terms of the out-of-sample forecast errors from Eq. (1) over the 

period from 2008 to 2013. As shown in the left panel of Fig. 6, the deviations from Okun's Law have been remarkably large 

and persistent. The historical residuals {1980-2007) have a standard error of 0.44 percent, so that a deviation of around 

- 1 percent would be expected to occur no more than once in a 20-year period. And given that the historical residuals are 

serially uncorrelated, a sequence of three consecutive deviations of that magnitude would be exceedingly rare, say, once in 

10,000 years. 

In interpreting these deviations from Okun's Law. one key element is that potential GOP growth appears to have shifted 

downward substantially in recent years.27 Indeed, CBO (2014) estimated that potential GDP growth had an average rate of 

.about 1.5 percent during 2011-2013, compared with an average rate of about 3 percent over the period 1980-2007. Using 

the estimated slope coefficient of 0.43 in Eq. ( 1 ), that decline in potential GOP growth would induce a downward shift in the 

residuals of about 0.65 percent-roughly half the magnitude of the forecast errors shown in the left panel of Fig. 6. 

However, it is also important to consider the possibility that the recent trajectory for unemployment may have at least 

partly reflected a decline in labor force participation that was induced by the sluggish pace of the economic recovery:c:{ 

Indeed. Okun himself flagged this issue in his classic paper: 

In a slack labor market, people without a job may give up when they are convinced that job-hunting is a hopeless 

pursuit. They then may be viewed as having left the labor force though they stand ready and eager to work. 

The response of participation rates is likely to be a complicated lagged phenomenon which will not be closely tied to 

the current unemployment rate. While this aspect of the difference between potentia! and actual output is hard to 

quantify, zero is certainly not a satisfactory estimate. (Okun 1962. pp. 5-6) 
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llncmployment Rate Employment Growth 

2.0 

!.5 

1.0 

0.5 

0.0 

-0.5 

-1.0 

-4 ----,-----,---,----·-,----,---~ 

2008 2009 2010 2011 20!2 2013 2008 2009 20!0 2011 2012 2013 

Fig. G. US. Deviations from Okun's Law. Note: This figure depicts out~of-sample forecast errors for 2008 to 2013 as implied by two versions of Okun's law 

estimated using U.S. annual data from 1980 to 2007. The left p.1ne! shows the forf'cast errors associated with equation (J ;. which is specified in terms of 

changes in the unemployment rate. The right pani'l shows the corresponding implications of equation which is specified in tenns of employment 

growth. In each panel, the shaded region denotes the 95 percent confidence interval based on the standard error of each regression. 

Thus, we now turn to the following variant of Okun's Law involving employment growth rather than changes in the 

unemployment rate: 

(2) 

where .6.et.denotes the growth rate of total employment (Q4/Q4). As above, this specification has a good fit over the sample 

period 1980-2007 (II'~ 0.69), and the residuals exhibit no serial correlation at all (DW = 1.74). 

The out-of-sample forecast errors from Eq. (2) are shown in the right panel of Fig. G. Notably, the forecast errors for the 

period 2010-2013 vary in sign from year to year and fall well within the 95 percent confidence interval-a much better 

out-of-sample fit than Eq. ( 1 }. These results bolster the view that the unexpectedly steep decline in unemployment over that 

timeframe was indeed related to the concomitant drop in labor force participation. 

4.2. The composition of labor market slack 

As discussed in the Bank of England's May 2014 Inflation Report, the employment gap can be represented as a sum of 

three components: the unemployment gap, the participation gap, and the underemployment gap. In particular, the 

unemployment gap is the deviation of actual unemployment from the NAIRU, and the participation gap is the deviation of the 

actual labor force from its equilibrium level. The underemployment gap refers to the incidence of involuntary part-time work 

relative to its normal level, that is, the incidence of individuals who are currently working part-time (less than 30 h/week) 

who would prefer to have a full-time job but are unable to tind one. 

The upper panel of Fig. 7 shows the Bank of England's assessments, as of May 2014, regarding the magnitudes of the 

specific components of the U.K. employment gap. Each component is scaled by its standard deviation over the period 1992-

2007 in order to retlect the extent to which the current magnitude of that gap exceeds its normal variability. Evidently, all 

three components became quite large in the wake of the global financial crisis and remained sizeable through 2011. As the 

U.K. labor market subsequently improved notably, the participation gap essentially disappeared and the unemployment rate 

reverted close to its normal level, whereas the underemployment gap remained about two standard deviations away from 

Bank staffs current assessment of its medium-term equilibrium. 

The lower panel depicts an assessment of the evolution of the total U.S. employment gap in terms of these three 

components. The unemployment gap refers to the deviation of actual unemployment from the CBO (2014} estimate of the 

NAIRU, and the participation gap refers to the difference between the actual size of the labor force and the CBO' (2014 J 

estimate of the potential labor force. The estimate of the underemployment gap shown here is obtained using a trend-cycle 

decomposition of the incidence of involunta1y part-time work; detailed information is provided in the appendix. Evidently, 

while U.S. labor market conditions improved substantially since 2010, this estimate suggests that the U.S. employment gap 
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62 AJ Levin j journal of Economic DynamiCs t?t Conlrol 49 (2014) 52-69 

United Kingdom 

2008 2009 2010 :wn 2012 lOB 2014 

United States 

2008 2009 2010 2011 21H2 2013 l0l4 

Fig. 7. The magnitude and composition of labor market slack. Note: In the upper panel (which borrows directly from Ch.m 3.7 of the Bank of England's May 

2014 !ntlation Report), the unemployment gap is the difference between the actual unemployment rate and the Bank staffs estimate of its medium-term 

equilibrium rate; the paJtidpation gap is the difference between the actual labor force participation rate and the Bank stafrs estimate of its medium-tenn 

equilibrium rate; the- under<'mployment gap is the difference between average weekly hours worked and Bank staffs estimate of its medium-term 

equilibrium level: and each of these gaps is scaled by its own standard deviation (computed for the period 1992-2007}. The lower panel depicts the level of 

the US employment gap (expressed in millions of full-time equivalent (FTE) jobs) and its components, where the unemployment gap is the deviation of 

actual unemployment from the CBO's estimate of its longer-run natura! rate, the p.11ticipation gap is the deviation of the labor force from the CBO's 

estimate of its potemiallevel, and the derivation of the underemployment gap is shown in the app<>nclix. 

remained quite large as of spring 2014 and that the participation gap and the underemployment gap accounted for the bulk 

of that gap.1 u 

5. Using simple policy rules as benchmarks 

"* Simple monetary policy rules can serve as valuable benchmarks in determining the course of monetary policy and 

explaining tfwse judgments to tile public. 

No macroeconomic model provides a completely satisfactory description of any economy in the real world. Indet.'d, the 

limitations of existing mJcroeconomic models have been underscored by the incidence of relatively large and persistent 

forecast errors in many advanced economies over the past few years. '

0 Thus, rather than relying on the monetary policy 

implications of any single macro model, it seems to be sensible to develop simple rules that provide reasonably robust 

performance across a range of plausible models. Such rules can serve as valuable benchmarks in the decision-making 

process and in explaining those decisions to the public. For example, following the seminal work of Taylor ( !~l93), a vast 

literature has investigated the specification and performance of simple monet.:uy policy rules of the following form: 

(3) 

where it denotes a me.1sure of the short-term nominal interest rate, r* denotes the equilibrium real interest rate, pir is a 

smoothed measure of inflation, pi* is the central bank's inflation objective, Xt -x;' is a measure of resource stack, and the 

coefficients a and fJ are chosen appropriately in order to foster the stability of economic activity and inflation. For example, 

the Taylor ( 1993~ rule was specified in terms of GOP price inflation and the output gap. with r = 2, Jt* = 2, and a=fJ = O.S.JJ 

panel data and found highly significant effects of rhe participation gap and the underemployment gap (Jll 

States and the United Kingdom, respectively. 

(2014). 

the seminal analysis of the "monetary policy frontier" in cenns of the relative variability of economic activity and inflation. 

reported on a comprehensive analysis of the performance of simple policy rules across a wide range of macroeconomic models. 
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Nonetheless, there are two distinct reasons why it would be inadvisable for policymakers to mechanically follow the 

prescriptions of a rule whose specification has been permanently fixed: 

• Economic conditions may occasionally arise that are not well-captured by any of the models that were used in 

formulating the policy rule. Thus, in certain circumstances policymakers might judge that the stance of policy should 

deviate temporarily from the path prescribed by the policy rule, and the rationale for doing so would need to be clearly 

explained to the public. 

• The salient characteristics of the set of plausible models will inevitably evolve over time, reflecting new economic and 

financial data and ongoing improvements in analytical and empirical methods as well as changes in the structure of the 

economy itsel[ Consequently, the central bank should have a systematic procedure for considering potential adjustments 

to the specification of its policy rule. Minor technical adjustments may occasionally be warranted, but the basic 

specification of the policy rule would not be modified unless there were compelling reasons for doing so. 

To illustrate these considerations, the remainder of this section focuses on two practical issues that are currently facing 

monetary policymakers in a number of advanced economies. It should be noted that a number of other important issuessuch as the appropriate degree of policy inertia or implications of uncertainty about natural rates-cannot be addressed 

within the scope of this paper.32 

5.1. The equilibrium real interest rate 

Conceptually, the equilibrium real interest rate is the level of shmt-term real interest rates at which the economy evolves 

along its balanced-growth path and inflation remains at its objective.'n Of course. as with other properties of the balancedgrowth path, the level of the equilibrium real interest rate cannot be directly measured but must be inferred from observed 

economic and financial data. For example, Taylor (1993} specified the value r* = 2 based on the historical average value of 

the real federal funds rate. 

However. there are strong conceptual and empirical reasons to expect that the equilibrium real interest rate may move 

significantly in response to a shift in total factor productivity growth that changes the pace of output growth along the 

balanced-growth path. Moreover, econometric analysis suggests that the level of r* may also vary over time in response to 

other domestic and global economic developments. Such shifts in the value of r* can be consequential for the performance 

of a simple policy rule. For example, if the economy were on its balanced-growth path (x1 ""' x:') but the true value of the 

equilibrium real interest rate were a percentage point lower than the value specified in the monetary policy rule, then 

inflation would persistently fall short of its objective: e.g., with a= 05, the prevailing inflation rate would be zero instead of 

2 percent. 

As shown in Fi,g. 8, professional forecasters' assessments of equilibrium real interest rates shifted downward substantially 

over the past few years. Prior to the onset of the global financial crisis, the consensus outlook for the far-ahead fotward real 

federal funds rate (left panel) was roughly in line with the value of 2 percent embedded in the Taylor (1993) rule. The 

consensus outlook subsequently declined to around 11/4 percent-a decrease that is roughly comparable to the reduction of 

about 0.6 percentage points in forecasters' longer-run projections for U.S. GDP growth (not shown). The dispersion in 

forecasters' views is evident from the interquartile range, which effectively covers the entire interval from 0 to 2 percent 

Substantial downward revisions in r* have also occurred for a number of other advanced economies (right panel).>1 

5.2. Measures of Inflation and Resource Slack 

For a policy rule like Eq. (3) to serve as a practical benchmark for monetary policy, the central bank needs to clarify which 

measures of inflation and resource slack will be used in computing its prescriptions. During normal times, the particular 

specification of those measures may be fairly innocuous. For example, a quarter-point difference between two measures of 

inflation would only imply a difference of about 40 basis points in the prescriptions of the Taylor ( 1993; rule, and a half 

percentage point difference between two measures of resource slack would only affect the Taylor rule's prescriptions by 

25 basis points. 

In contrast, when a large shock has pushed the economy relatively far away from its balanced-growth path, the 

specification of the measures of inflation and resource slack may become highly consequential. For example, ·!ay!or's ( 1993-) 

rule was specified in terms of the output gap, which CBO (20!4} estimated at -4.3 percent as of 2014:Q1. Thus, with the 

coefficient fJ = 0.5, the Taylor rule would imply a funds rate reduction of about 2 percentage points (assuming a constant 

value of r* and with inflation at its target rate). 

32 OrplMnii\(''> ,1nd William~ (20-01; analyzed the implications of uncertainty about potential output and the natural rate of interest in the formulation 

\Voodford (2003 J analyzed the benefits of history dt>pendence when the policy instrument is constrained by thP 

it is evident that the real interest rate i1 - pi1 is equal to r* when Jt- W and x1 = x7. 34 furcen Pe~tat{);i (?.014; provide comprehensive analysis of the evolution of global real mterest rates over the past several decades and in the 

wake of th(' financial crisis. 
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64 

Percent 

3.5 

3.0 

2.5 

2.0 

1.5 

1.0 

0.5 

0.0 

2006 2008 

A.T. I.evm J journal of Economic Dynamics & Contm/49 (2014) 52-69 

United States 

-- Blue Chip cons('nsus 

lntcrquartilc Range 

2010 2012 2014 

4.5 

4.0 

3.5 

3.0 

2.5 

2.0 

1.5 

1.0 

Other Advanced Economies 

---- Canada 

2006 2008 2010 2012 2014 

Fig. 8. The t>volution of professional forecasters' assessments of equilibrium real interest rates. Nor(': The left panel shows the wnsrnsus outlook (solid 

line) and intcrquartile range (shad<•d area) of professional forecasters' projections for the avNage level of the U.S. 3~month treasury bill rate 6-10 years 

ahead.less the consensus of their projections for the average level of U.S. CPI inflation 6 to 10 years ahead, computed <IS a moving aver.:~ge of the latest two 

semiannual Blue Chip Economic Indicators longer-run surveys. Copyright (c) Aspen Publishers, Inc. The right p<lnel shows corresponding results t<1ken from 

Consensus Economics' semiannuallonger~run surveys regarding the expe<:'ted average level of 10-year Treasury bond yields 6 lo 10 ye,lfs ahead less the 

expected average level of CPI inflation 6 to 10 years ahead; these results .lre shown for Canada (short-dashed), Gem1any (dot~dashed), jdpan {dot-dotdashed), Switzer!.and (solid), and the United Kingdom (long-dashed). Copyright (c) Con.~ensus Economics Inc 

One plausible alternative would be to use the unemployment gap as the measure of resource slack. Indeed. Orphanides 

and Williams (2002) suggested that the prescriptions from the following rule would be roughly equivalent to those of the 

Taylor rule: 

(4) 

where u, denotes the actual unemployment rate, uf denotes the NAIRU. and the coefficient of - 1.0 on the unemployment 

gap was based on the usual application ofOkun's L,1w._\ 3 CBO (2.014) estimated that the NAIRU would remain steady at 5.5 

percent through the remainder of this decade, implying that the unemployment gap was about 0.75 percentage points as of 

mid-2014. Consequently, according to this specitication, the prevailing degree of resource slack would only call for a modest 

funds rate reduction of less than a percentage point, all else equal. 

Conversely. the preceding analysis in Se(tion 4 may provide a compelling rationale for specifying the benchmark rule in 

terms of the employment gap rather than the unemployment gap. especially when there are large and persistent deviations 

from the unemployment rate version of Okun's law. As shown in the lower panel of 7, the total U.S. employment gap 

was close to 3.5 percent as of 2014:Q1-that is, about three times as large as the unemployment gap. Consequently, using the 

same coefficient of --1.0 as in the preceding specification, this measure of resource slack would call for a funds rate 

reduction of about 350 basis points, all else equal. 

6. Communication tools 

6.1. Post-meeting statements and press conferences 

=l> The head of the moneta1y policy committee should hold a press conference following every regular~scheduled meeting. 

In recent years, there have been numerous inst.mces in which an abrupt shift in the economic outlook has warranted a 

prompt and decisive monetary policy response. That experience has underscored the importance of having regular 

monetary policy meetings at which policymakers can carefully consider the incoming economic and financial information 

and determine whether any action would be appropriate at that particular juncture. Moreover, policymakers need to be 

prepared to provide a prompt explanation to the public regarding the rationale for each policy decision, regardless of 

whether the decision involves action or inaction. 

In all of the advanced economies, the monetary policy committee has a regularly scheduled meeting every few weeks. 

For example, the Bank of England's MPC and the Bank of japan's policy board each convene on a monthly basis, while the 

35 See the discussion of Eq. (1) in Orphantdes -tlld Williatn~ (2002). 
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A.T. f.evin j joumal of Economic DynamiCS [7' Connol 49 (2014) 52-69 65 

2006 2007 2008 2009 20H} 20ll 2012 2013 lfll4 

Fig. 9. The evolution of FOMC meeting statements. Note: This figure shows the number of words in each of the FOMC statements that were issued in 

conjunction with reguLarly scheduled meetings from M.uch 2006 through April 2014. This word count does not include voting tallies, dissenting views 

(if any). or S<'parate decisions of the Federal Reserve Board (as distinct from the FOMC). The content of each FOMC st.nement is categorized as follows: 

(i) the Committee's policy decision, that is, the actions taken at the meeting as well as any forw.ud guidance about the likely future path of policy; and 

(ii) the Committee's economic rationale, including its synopsis of recent developments and its description of the economic outlook and the ha!,mcl.' of risks. 

FOMC and the Bank of Canada's governing council each hold meetings eight times per year.·{;; Of course, a monetary policy 

committee can also convene unscheduled meetings as needed-either in person or via conference call-but such meetings are 

quite rare apart from crisis situations. 

The standard practice for every monetary policy committee is to issue a written statement following the conclusion of each 

regularly scheduled meeting. but the purpose and structure of such statements varies significantly across central banks. 

In some cases, the post-meeting statement is very brief and simply conveys the substance of the current policy decision. For 

example, following its meeting on 8 May 2014, the ECB issued the following statement: "At today's meeting, which was held in 

Brussels, the Governing Council of the ECB decided that the interest rate on the main refinancing operations and the interest 

rates on the marginal lending facility and the deposit facility will remain unchanged at 0.25 percent, 0.75 percent, and 0.00 

percent, respectively." On the same day, the Bank of England released the following statement: "The Bank of England's 

Monetal}' Policy Committee at its meeting today voted to maintain Bank Rate at 0.5 percent The Committee also voted to 

maintain the stock of purchased assets financed by the issuance of centr.:tl bank reserves at 375 billion." 

In contrast, some central banks-including the Bank of Canada, the BOJ, and the FOMC-generally issue much longer postmeeting statements that provide a specific description of the policy decision and explain the economic rationale for that 

decision. As shown in Fig, 9, FOMC statements typically comprised about 150-200 words during the first two years of 

Chairman Bernanke's tenure in 2006-2007. The total length of FOMC statements surged during the financial crisis and 

continued rising over subsequent years to around 800 words by spring 2014. That upward trend mainly reflected the increased 

complexity of policy decisions involving large-scale asset purch<Ises and forward guidance about the pace of purchases as well 

as the timing and pace of liftoff of the federal funds rate from the zero lower bound. In addition, the economic rationale in each 

FOMC statement was also expanded from about 100 words prior to the crisis to around 200 words more recently. 

It has also become standard practice for central banks to hold regular press conferences at which the head of the monetary 

policy committee presents some opening remarks and then engages in Q&A37 The media participants typic .. 11ly represent a wide 

spectrum of news outlets, including mainstream and social media as well as the finandal press. Consequently, central banks have 

generally found press conferences to be an effective platform for explaining the central bank's policies to the general public as 

well as for addressing more specific points that are relevant for analysts and other specialists. The frequency of press conferences 

varies noticeably across central banks. TI1e Feder.:ll Reserve Chair holds a press conference following each quarterly FOMC 

meeting at which committee participant<; update their assessments of the economic outlook. At the Bank of Canada and the Bank 

of England, press conferences are held once per quarter in conjunction with the release of monetary policy reports. In contrast, at 

the BOJ and the ECB, press conferences take place every month at the conclusion of each monetary policy meeting. 

Recent experience points to the merits of relatively frequent press conferences and the limitations of post-meeting 

statements. For example, as shown in the left panel of Fig. 10, all of the significant revisions to the FOMC's policy decisions 

from early 2012 through spring 2014 occurred in conjunction with quarterly press conferences. In principle, of course, the 

FOMC could make substantive adjustments to its policy stance at any meeting, even if there were not any press conference 

afterwards. But the reality is that 30-60 min of Q&A can provide a much more comprehensive explanation than a few 

hundred words in a written statement. Indeed, as shown in the right panel of the figure. revisions to the economic rationale 

in FOMC statements over the past few years rarely involved changing more than about 50 words. Consequently. there seems 

to be a strong case for arranging press conferences to be held in conjunction with every regularly scheduled meeting, so that 

the monetary policy committee has the flexibility to take action whenever warranted while ensuring that such actions are 

clearly and promptly communicated to the public. 

36 The ECB's governing council has traditiona!Jy held monthly policy meetJngs but recently announced that it Wlll be shifting to a schedule of eight 

monetary policy meetings per year starting in 2015. 

:n At some central banks. one or more cleputies also participate in the press conference and assist with the Q&A 
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66 A. I Levin jjoumal of Economic Dynamics & Control 49 (2014) 52-69 

Policy Decision 200~------·---·-·-----C~-----------------

160 

120 

2012 

I! Ill IV 

20B 

II 

2014 

Economic Rationale 100~------------------------~-----

90 

80 

11 Ill IV 

2012 

II Ul IV 

2013 

!I 

2014 

Fig.. 10. Revisions in FOMC statement language (number of word changes from previous FOMC statement). Note: Thts figure depicts the incidence of 

revisions to the FOMC sta!ement issued after each regularly scheduled meeting since january 2012 compared with the FOMC statement from its previous 

regu!Mly scheduled meeting. The number of revisions is obtained by counting how many words have been inserted or modified (not incl\lding 

rC'a!T,mgements in word ordt>r). The decomposition of the content into the policy decision (left panel) and economk r,nionale (right pane!) is described in 

the notes to the preceding figure. In each panel, the shaded bars denote instances in which the Federal Reserve Chair h&!d a press conference following the 

conclusion of the FOMC meeting, and the dashed line indicates the mean number of revisions which were made at FOMC meetings that did not include <1 

~ness conference. 

62. Monetary policy reports 

o;- The central bank should publish quarterly monetary policY reports that provide a detailed rationale for its policy 

decisions. 

Press conferences and post-meeting statements are valuable tools for communicating broadly to the general public. 

However, it is also essential for the monetary policy committee to publish more detailed information about the rationale for 

its policy decisions. Such reports can be particularly helpful in ensuring that professional forecasters and financial market 

an~1lysts have a clear understanding of the central bank's policy strategy, thereby reducing economic and tinanciai 

uncertainty and facilitating the effectiveness of the moneta1y transmission mechanism. Such reports are also highly relevant 

for academic economists, who often play a key role in evaluating the central bank's policy framework and in contributing to 

its public accountability over time. 

fn particular. regular monetary policy reports can provide crucial information about the central bank's assessments of the 

economic outlook and the balance of risks. Such reports provide a means of discussing the specific details of economic and 

financial developments-and the methods used in analyzing those developments-that go well beyond the intrinsic limits of 

what can be communicated in a post-meeting statement or a press conference. Moreover, as noted above, monetary policy 

reports can present the implications of alternative scenarios thal illuminate key risk-management issues. 

From a practical standpoint, monetary policy reports are largely prepared by the central bank's staff. Consequently, such 

reports are typically viewed as effectively representing (either implicitly or explicitly) the views of the head of the monetary 

policy committee. However. such reports can also seJve a valuable role in presenting the diversity of views of the entire 

committee. For example, the Bank of England's May 2014 Inflation Report frequently utilized phrases like "the central view of 

most MPC members" and "a range of views on the Committee." 

7. Conclusions 

Clarity and transparency of communications play a key role in enhancing the effectiveness of monetary policy and in 

sustaining the central bank's operational independence over time. In recent years. many central banks around the world 

have made significant improvements to the clarity of their communications. However. such communication will inevitably 

be a work-in-progress that requires continual effort and engagement with the public. Moreover, there are numerous 

dimensions of policy strategy and communication for which further research is warranted by economists at central banks 

and international organizations as well as at academic institutions. 
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AJ: Levin/ Journal of EconomiC Dynamics&' (antral 49 (2014) 52-69 67 

fig. A1. Trend-t_-yde derompositlon of U.S. mvohmtary parHime 

Fig. A2. The nMp;nilude and composition of the US C'mployment gap since 

Appendix A 

This appendix describes the methodology used to construct each of the three components of the US employment gap 

that are depicted in the lower panel of fig. 7. The unemployment gap is the deviation of the civilian unemployment rate from 

the CBO (2014 l assessment of the longer-run NAIRU. and the participation gap is the percent deviation of the actual labor 

force from the CBO (2014) assessment of the potential labor force." The rmderemployment gap is defined as the number of 

full-time equivalent (FfE) jobs (expressed in proportion to the potential labor force) that would be required to eliminate the 

cyclical component of involuntary part-time work. 

To construct the underemployment gap, the following three monthly time series were downloaded from the BLS 

website: (a) number of individuals working part-time for economic reasons (seasonally adjusted, BLS Identifier 

LN$12032194); (b) average hours per week of individuals working part-time for economic reasons (not seasonally adjusted, 

BLS Identifier LNU02033232); and (c) average hours per week of individuals who usually work full-time (se<1sonally 

ddjusted, BLS Identifier LN$12505054). Henceforth these three series are denoted as NJNV, HJNV, and HFULCn The relative 

shortfall in hours per week is given by HRATJO =HI NV jHFULl..<Jn 

Next, the incidence of involuntary part-time employment was normalized by the potential labor force. i.e., 

INVRT = 100*NINV jLFPDT. The trend-cycle decomposition of INVRT was obt•ined by applying Eviews HP filtering algorithm 

over the sample period 1960:1 to 2007:12. where the smoothing parameter of 129,600 was determined by the Uhlig-Ravn 

formula. To project the trend beyond 2007, its monthly average change was computed for the period 2005:1 to 2007:12, and 

the (BO (2014) series were published at an annual frequency, Eviews was used 

average method. 39 The Eviews X13 procedure was applied to HJNVOL, since the BlS does not publish a seasonally adjusted version of that series. 

4ll The Bl5 series on full-time hours is only available starting in 1994:1, and hence the mean valueof0.535 for HRADOover the post~1994 sample was 

used in constructing the underemployment gap for al! penods prior to 1994. 
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68 AT. Levin/ )ouma! of Econonnc Dynamics & Contro/49 (2014) 52~69 

that slope (namely -0.0015) was used to extend the trend linearly from 2008:1 to 2014:4. The cyclical component 

JNVCYCLE...,.. JNVRT- JNVTREND; the resulting trend-L-ycle decomposition is shown in Fig. A l. Finally, the underemployment 

gap is obtained as (1-HRATJO)*JNVOLCYCLE. 

Using these methods, fig. /\2 depicts the evolution of the magnitude and composition of the U.S. employment gap over 

the past five decades. 

References 

Aaronson, D., Davis, J-, Hu. L, 2012. Expl.:tining the Decline in the U.S. Labor Force Participation Rate. Chicago Fed ~tter #296, Federal Rese1ve Bank of 

Chicago. 

Alichi, A .. Fe!man,J., Fernandez Corugedo, E .. Laxton, D., Natai,J., April 2014. Anchoring inflation expectations wh~n inflation is undershooting (Box 1.3), In: 

World Economic Outlook. International Monetary Fund. Washington DC, pp. 41~43. 

L, 2013. Okun's Law: Fit at Fifty? National Bureau of Economic 

:~n11. 1\!c intlarit.n t:'Xpd:t,,:\(!11~ Hrmlv 

(Jrney, M., 2011. Renewing Canada's Monetary Policy Framework. Remarks given at the Board DfTrade of Metropolitan MontreJI, November 23. Available 

.Jt (!\tlp:if1NW'N.b<lnkok:UMd<i.C.!/20J! ·JJ lf<~!l\"Whl~~-C,\1\<KJ,H\}(Hld,liY·pniKy-fl,))lWW!lrk). 

Congressional Budget Office, 2014, The Budget and Economic Outlook: Fiscdl Ye.us 2014-2023, February. 

DJ!y, M., Fernald, j., jorda, 0 .. Nechio, f., 2014. Labor Markets in the CioN! Financial Crisis: The Good, the Bad and the Ugly. Ff'deral Reserve B.Jnk of S<ln 

Frandsco Working Paper 2014-11. 

D'Amico, S .. Orphanides, A., 2008. Uncertainty and Disagreement in Eronomic Forec.asting. Finance:' and Economic Discussion Senes 2008-56, Board of 

Governors of the Federal 
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A.T. LI?Vin I journal of Economic Dynamics & Control 49 (2014) 52-69 

'Ed ). :vton<'tdry l'r,licy Ru!e~. Unive•·siry of Chicago Prc~or. 

Bandbook of Monet.1ry Economics. 

69 

Central Bank. june 5. AvaJ!able at <hltps:/,\rvww.,;:rJ).enropu.eu·press; 

Economic Review, Federal Reserve Bank of Kansas City, pp. 5-34. 

of New York, April 16. Available at {http:rJw;.vw. 
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Monetary Policy for Healthy Economic Performance 

Mickey D. Levy* 

Testimony before the Subcommittee on Monetary Policy and Trade 

Committee on Financial Services 

U.S. House of Representatives 

November 7, 2017 

Chairman Barr, ranking member Moore and members of the Committee, I appreciate this opportunity to 

present my views on the Federal Reserve's monetary policy. I begin with the ultimate goal of sustained 

healthy economic growth and higher standards of living. This of course is a laudable objective, but it 

requires the correct set and mix of policies. Policymakers must identify which policy tools are 

appropriate to achieve desired economic performance and the proper mix of policies. While fiscal, tax 

and regulatory policies heavily influence economic outcomes, today's hearing focuses on the Fed's 

conduct of monetary policy. 

Two things have become obvious during the 2002-2007 economic expansion that was marked by the 

debt-financed housing bubble, the financial crisis and deep recession of 2008-2009 and the current 

lengthy but slow-growth expansion. First, monetary policy plays a critical role-and serves best by being 

even-keeled and pursuing a low inflation target during expansions and actively countercyclical in 

response to downturns and financial crises. Second, there are limitations to what monetary policy can 

achieve, as some of the sources of under-performance in the economic and labor market are beyond the 

control of monetary policy and best addressed through other economic, fiscal and regulatory policiesand pushing monetary policy beyond its limits does not improve performance but instead generates 

risks and uncertainties that undercut desired economic objectives. 

The Fed's creative emergency measures during the 2008-2009 crisis helped stabilize financial markets 

and avert an even deeper and more damaging recession, but the efficacy of its sustained artificial low 

interest rates and massive asset purchases, well after the start ofthe economic recovery is 

questionable. It has not stimulated faster growth and has distorted economic and financial 

performance, and poses sizeable risks. 

*Chief Economist of Berenberg Capital Markets, LLC for the Americas and Asia, and member, Shadow 

Open Market Committee. The views expressed in this paper are the author's own and do not reflect 

those of Berenberg Capital Markets, LLC. 
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The Fed's efforts to stimulate economic growth and employment, lift wages and improve other labor 

market conditions has extended the role of monetary policy beyond its normal scope. The Fed's 

massive asset purchase programs and maintenance of an excessively large balance sheet have crossed 

the border into fiscal policy and credit allocation. Confusion about the proper role of monetary policy 

and what it is capable of achieving relative to tax, fiscal and regulatory policies has made Congressional 

oversight of the Fed much more difficult. 

The economy is now growing on a self-sustaining basis and is far beyond the point of needing the Fed's 

excessive monetary ease as a crutch. Now it is time to institute changes that set monetary policy on a 

course consistent with sustained healthy economic performance and establish a framework for dealing 

with emergency situations. The Fed should continue to normalize interest rates and modify its balance 

sheet unwind strategy. A framework needs to be established that clarifies the proper scope and 

operational conduct of monetary policy during emergency situations, along with the roles of the 

Treasury and Congress. 

The Expanded Scope of Monetary Policy 

Even after the economic recovery gained traction and was self-sustaining, the Fed dramatically 

expanded its balance sheet through massive purchases of treasury and mortgage-backed securities 

{MBS) while maintaining zero interest rates, all in an effort to stimulate economic growth and job 

creation. The Fed's macroeconomic models predicted that through the "real balance effect", 

maintaining low rates and providing more excess liquidity would encourage risk-taking and push up 

asset prices, all of which would stimulate faster growth in aggregate demand. 

In reality, the Fed's QEIII and forward guidance stimulated financial markets and home values as 

predicted, but the response of aggregate demand was tepid at best-in fact, nominal GDP, the broadest 

measure of current dollar spending in the economy, actually decelerated. In the four years following the 

implementation of QEIII {through 2016Q4), nominal GDP growth averaged 3.7%. Most striking, business 

investment growth remained disappointing even though the Fed was successful in reducing the real 

costs of capital and business profits and cash flows were rising to record levels. Employment rose and 

the unemployment rate receded, but wage gains fell far shy of expectations. 

The economy would have grown along its modest pace and jobs gains would have occurred even if the 

Fed had not engaged in its asset purchases and would have gradually normalized interest rates. Not 

surprisingly, the Fed's interpretation of the slow growth has been different. It takes full credit for the 

2 
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increase in employment. Until recently, the Fed argued that any monetary policy normalization would 

have sidetracked the economic expansion. These positions seem to reflect a good deal of hubris, but 

nevertheless led the Fed to delay unwinding its balance sheet out of fear of any negative repercussions 

on the economy or financial markets. 

History has shown clearly that following countercyclical monetary accommodation, once an economic 

recovery from recession has taken hold, Fed rate increases back to neutral do not harm economic 

growth. Granted, there is no experience of unwinding an excessively large balance sheet, but it is highly 

unlikely that a gradual unwind that still leaves an ample amount of excess bank reserves would harm 

performance. 

The economy's lackluster response to the Fed's stimulus highlights the important influences of other 

factors and policies, and the Fed's limitations in achieving certain economic objectives. The Fed's efforts 

to stimulate the economy through monetary policy have been countered to a large degree by 

counterproductive government tax and regulatory policies. In general, a growing web of regulatory 

burdens and uncertainties about future tax and regulatory policies-at the Federal and state and local 

levels in both the financial and nonfinancial sectors-have constrained economic activity. 

Banks have been deterred from lending by the burdensome regulations imposed by Dodd-Frank and the 

Fed's stress tests, as well as the Fed's policy of paying interest on excess reserves (IOER), which may 

have led banks to park excess reserves at the Fed. These factors have clogged the monetary policy 

channels. In the nonfinancial sector, the increasingly burdensome tax and regulatory environment has 

constrained business and household spending. Of note, uncertainties about these government-imposed 

burdens have led businesses to raise their required hurdle rates for investment projects, offsetting the 

attractiveness of low costs of capital. This has led businesses to scuttle investment expansion plans. 

The Fed's overly-cautious forward guidance ("if we raise rates at all it may throw the economy back into 

recession") may have added to business and household caution. In addition, low interest rates have 

increased demand for holding money. As a result of these factors, despite the dramatic surge in the 

Fed's monetary base resulting from the Fed's asset purchases, in recent years M2 has grown at a 

modest 6% rate and nominal GOP has grown even more slowly, reflecting the persistent decline in 

money velocity. 

Along with weak productivity gains, the tepid response of nominal GOP to the Fed's 

unprecedented efforts to stimulate activity has been a key reason why inflation has remained below the 

3 
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Fed's 2 percent target. Along with soft productivity gains, it has also served to constrain wage increases. 

Inflation results from excess aggregate demand relative to real productive capacity. With nominal 

spending growth during this expansion through 2016Q4 hovering around 3.5% and estimates of real 

potential growth centering close to 2%, inflation has settled around 1.5%. To put this into historic 

context, nominal GOP grew 5.3 percent annualized during the 2001-07 expansion and at a 5.6 percent 

pace during the 1990s. 

In addition to the slow productivity, soft growth of aggregate product demand has influenced wage and 

price setting behavior. Businesses know that the soft aggregate product demand environment 

constrains their flexibility to raise product prices, which reduces their willingness to grant higher wages. 

In the last two quarters (2017Q3-Q4), nominal GOP has accelerated to a 4.6% growth pace and 

productivity has picked up. If these trends are sustained, wage gains will rise. 

The Fed's Balance Sheet 

The Fed's asset purchases ballooned its balance sheet to $4.45 trillion by mid-2014. The Fed's policy of 

reinvesting maturing assets has maintained that level of assets. The Fed's portfolio includes $2.5 trillion 

of U.S. Treasury securities of various maturities and $1.8 trillion of MBS, primarily with long maturities. 

The Fed is now the largest holder of each, with 17 percent of outstanding federal publicly held debt and 

12 percent of MBS outstanding. (The Fed's holdings ofTreasuries are counted as publicly-held debt 

because the Federal Reserve Banks are legally capitalized by the private-sector banks in their districts). 

Prior to the financial crisis, the Fed's balance sheet was roughly $850 billion, comprised nearly entirely 

of short-term Treasuries and other liquid securities. 

The Fed's out-sized balance sheet and its MBS holdings directly infuses monetary policy into fiscal and 

credit policies, and involves significant risks, including risks to the Fed's independence. The Fed's 

significant earnings-it effectively funds its long-dated portfolio with short-term borrowing-are 

remitted to the US Treasury. These remittances peaked at $117 billion in Fiscal Year 2015 and have 

receded to roughly $81 billion as average bond yields have fallen and the Fed has raised its Federal 

funds rate, which triggers higher IOER to commercial banks. These remittances have reduced budget 

deficits, but they entangle the Fed's monetary policy in the government's budget and fiscal policy in 

unhealthy ways and involve sizeable risks to current and future taxpayers. 

Congress has a tendency to view the Fed's remittances as risk-free and permanent (it has already taken 

advantage of the Fed's balance sheet and profits to fund some spending legislation) and maintaining the 

4 
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Fed's balance sheet involves sizeable interest-rate risks. Such risks may undercut the Fed's credibility 

and threaten its independence. The interest rate risks should be taken seriously. The Congressional 

Budget Office has estimated that a 1 percentage point increase in interest rates would raise budget 

deficits by $1.6 trillion over its 10-year projection period. Such a rise from current low levels would not 

be a surprise: the Fed's official forecasts call for a rising Fed funds rate, sustained economic growth and 

2% inflation, and economic momentum is building. 

The Fed's efforts to be more transparent about monetary policy should include a clear and honest 

assessment of the government's budgetary risks of its sustained outsized balance sheet. Congress must 

be more aware of the interest rate risks, and understand that taking advantage of the Fed's 

contributions to temporarily reducing deficits to finance spending programs is inappropriate and 

imprudent. 

The Fed's sustained holdings of MBS directly involve the Fed in credit allocation and are inappropriate. 

The Fed's first MBS purchases at the height of the financial crisis in November 2008 had a distinct 

purpose-to stabilize a completely dysfunctional and illiquid market that posed a threat to global 

markets. Soon after these first purchases, then Fed Chair Bernanke stated that the MBS purchases were 

in response to an emergency situation, and that the Fed would unwind them on a timely basis. Instead, 

the Fed added dramatically to its MBS holdings through QEII, QEIII, and has maintained them through its 

reinvestment policy. 

The Fed's MBS holdings effectively favor mortgage credit over other types of credit. Mortgage markets 

are functioning normally with sufficient liquidity, and even a casual observation of the housing market 

suggests that the Fed's ongoing explicit subsidies of the housing sector are irrational. 

The Fed's LSAPs have not involved purchases of equities. Some financial market participants and fiscal 

policymakers have argued that it may occasionally be appropriate for the Fed to buy equities. It is not, 

under any circumstances. In emergency situations-so-called "unusual and exigent circumstances"-

the Fed's efforts to stabilize financial markets would be much better served through temporary loans of 

other specified liquid financial securities, without the excess economic and political baggage of 

absorbing equities into its portfolio. Purchases of equities would be very risky on many dimensions, and 

should be deleted from the Fed's potential monetary policy "tool kit". 

5 
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Recommendations for the Conduct of Monetary Policy 

The Fed should continue to normalize monetary policy: it should continue to raise rates, but it should 

modify its balance sheet unwind strategy to gradually eliminate its entire holdings of MBS and aim to 

reduce its total asset holdings more than it is currently suggesting. These steps would not harm the 

economic expansion but would reduce distortions and improve the health of financial markets while 

reducing the risks involved in the Fed's current balance sheet policies. 

In addition, the Fed needs to adopt a flexible rules-based approach of conducting monetary policy and 

establish clearer rules for when and how it executes emergency monetary operations. The roles of the 

Treasury and Congress must also be clarified. A flexible rules-based approach would be a favorable 

change from its current discretionary approach, increasing its transparency and enhancing the ability of 

Congress to supervise the Fed. 

Interest rate and balance sheet normalization. Currently, the Fed funds rate is below inflation even as 

the real economy is growing above standard estimates of potential and gaining momentum. The Fed 

should continue to raise its target rate toward the natural rate of interest plus the Fed's 2 percent 

longer-run inflation target, consistent with its official forecast of the appropriate path of the Fed funds 

rate. 

With the economy operating near estimates of potential and the unemployment rate below estimates 

of its natural rate, an acceleration of economic growth would naturally require quicker rate increases, 

while a material economic slowdown should slow the pace of normalizing rates. Tax or fiscal legislation 

that raises economic growth and expected returns on investment would be associated with a rise in the 

natural rate of interest. This should lead the Fed to adjust up its trajectory and end-point of the 

appropriate Fed funds rate. 

The Fed should maintain its longer-run inflation target of 2 percent, but tolerate a lower range of 

inflation if inflationary expectations remain well-anchored and are not a factor that influences 

household or business spending and investing decisions. This is more in keeping with the VolckerGreenspan consensus during the successful economic period known as The Great Moderation. The Fed 

should express less worries that inflation is too low; rather, the low inflation is favorable for economic 

performance. The Fed must tone back its tendency to fine-tune the economy and acknowledge that its 

best contribution to sustained healthy economic growth is to maintain an even-keeled monetary policy 

consistent with stable, low inflation. 

6 
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The Fed has embarked on its current strategy of very gradually and passively unwinding its large 

portfolio of treasuries and MBS that involves reinvesting all but a small fraction of maturing assets ($6 

billion per month in treasuries and $4 billion per month in MBS). It will gradually increase those 

amounts of unwind as deemed appropriate. The Fed has not set an official strategy for the size of 

balance sheet it ultimately aims to maintain, but several Fed members have stated that the goal should 

be to keep the balance sheet sufficiently large in order to maintain a large amount of excess bank 

reserves. Governor Jerome Powell, the nominee to be Fed Chair, has stated the aim of reducing the 

Fed's portfolio to $2.5-$3.5 trillion. Based on the current $1.5 trillion in currency in the economy, this 

implies the Fed would maintain over $1 trillion of excess bank reserves. Other Fed members have 

mentioned $3 trillion. 

This strategy should be modified in two ways. First, the Fed should reset its strategy to fully unwind its 

MBS portfolio, but make it sufficiently gradual such that the mortgage market is allowed to absorb the 

Fed's reduced role in the MBS market. Although the bulk of the Fed's MBS holdings are of long 

maturity, their duration is significantly shorter, reflecting the natural amortization of mortgages and 

principle pay downs. Accordingly, this MBS unwind likely could be nearly fully achieved over a five year 

time period. The key point is the Fed should establish a reasonable unwind strategy and stick to it. 

The Fed's intention of maintaining a large balance sheet and buffer of excess reserves implies a shift 

from pre-financial crisis operating procedures. The Fed would continue to remit substantial profits to 

the Treasury. Under this procedure, the Fed would continue its post-crisis policy to pay IOER and 

manage the effective Federal funds rate through a "floor system". This contrasts to its historic reliance 

on a market-based "corridor system". The Fed's argument for this new strategy is that it would benefit 

the Fed's conduct of monetary policy and enhance its ability to stabilize financial markets. I am not 

convinced of the benefits of this new procedure relative to its costs in terms of the Fed's expanded 

financial footprint and its ongoing exposure to fiscal policy and associated economic and political risks. 

However, this preference is less important than the higher priorities of fully winding down the Fed's 

MBS holdings and reining in the scope of monetary policy. More thorough cost-benefit analysis of this 

issue is required rather than agreeing to the Fed's arguments. 

Resetting monetary policy. Resetting monetary policy to a flexible rules-based approach would steer 

the Fed away from a fully discretionary approach and its short-term oriented tendency to fine-tune the 

economy toward a flexible rule that operates as a guideline that focuses the Fed on a longer-term 

7 
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strategy of achieving its dual mandate. One benefit of this approach would lead the Fed toward 

conducting monetary policy within its natural scope and avoid discretionary polices that historically have 

been the source of mistakes and undesired economic outcomes. 

The debate about implementing a rules-based policy has been influenced by the notion that it would 

unduly constrain the Fed and prevent it from responding to an economic downturn or financial crisis. 

That is not its intention or the intention of pending legislation. Rather, a rules-based approach would be 

used as a guideline, and would allow the Fed to deviate from the rule, but require that the 

Fed explain those deviations to Congress and the public. This would improve transparency and facilitate 

improved Congressional supervision of the Fed. It would also be an important tool for reaching an 

understanding about the limitations of monetary policy and its proper role among other economic 

policies in achieving desired economic objectives. 

Analysis shows that more rules-based policy over time would have generated smoother fluctuations in 

aggregate demand and improved economic performance compared to actual policy; but once again, 

such a framework must provide sufficient flexibility to quickly and aggressively maneuver monetary 

policy amid financial crisis or economic downturn. My observation is such a rules-based guideline would 

result in even-keeled monetary policy during normal times, and the efficacy of monetary policy during 

extraordinary times would depend on the discretion, judgment and leadership of the Fed, as is currently 

the case under fully discretionary policy. 

Establishing the ground rules for emergency monetary policy. Ground rules need to be established for 

the conduct of monetary policy under extraordinary circumstances, including approval processes and 

responsibilities of the Fed, Treasury and Congress. Many of these governance issues are complex, but 

several things seem clear. While precisely defining emergency situations-unusual and exigent 

circumstances-that require extraordinary Fed intervention is difficult, responsibilities and approval 

processes within and across institutions must be established, and Congressional oversight of Fed 

operations must be open. I view several items as important. The Fed's governance rules should be 

modified such that Fed decisions to engage in extraordinary monetary policy should be determined by 

the FOMC, rather than just the Board of Governors. The Treasury should be mandated to approve the 

Fed's extraordinary interventions and capital exposure. The Congress should be involved in approving 

the budgetary impacts of the Fed's emergency policies, and its supervisory role should be spelled out. 

The Fed, Treasury and Congress have learned a lot from the financial crisis, and they should coordinate 

to be prepared for future economic, financial or idiosyncratic shocks. 

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Testimony before the Subcommittee on Monetary Policy and Trade 

Committee on Financial Services 

U.S. House of Representatives 

November 7, 2017 

Why the Fed Should Only Own Treasuries 

By 

Charles I. Plosser 
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Why The Fed Should Only Own Treasuries' 

By 

Charles I. Plosser 

Visiting Fellow 

Hoover Institution, Stanford University 

One of the most important guiding principles of sound central banking is the independence of monetary 

policy decision-making. History teaches us that unless governments are constrained constitutionally or 

by statute, they often resort to the "printing press" to avoid making tough fiscal decisions. But in a 

democracy, independence must come with limitations on the central bank's authorities and 

discretionary powers. Otherwise, central bankers can use their powers to venture into policy realms 

unrelated to monetary policy, especially fiscal policy, which more appropriately rests with elected 

officials. If a central bank has the power and willingness to conduct fiscal policy, it undermines the 

integrity of fiscal choices by Congress and the checks and balances on the distributional effects of fiscal 

actions. Engaging in such actions also undermines the central bank's legitimacy and the case for 

independence. 

It is useful to think of a central bank in terms of its balance sheet. For the Federal Reserve, the liabilities 

are predominately currency and the reserves ofthe banking system. Increasing the liabilities is often 

thought of as monetary policy. However, central banks also manage the asset side of the balance sheet 

and governments often put constraints on what the central bank can acquire or hold. Changes in the 

composition of the assets are often referred to as credit policy. 

Historically, the Fed has conducted monetary policy through the purchase or sale of Treasury or 

Treasury-related securities (such as repurchase agreements). Thus, the vast bulk of Federal Reserve 

assets has been Treasury securities. Credit policy did not play a significant role as assets outside of 

Treasuries were relatively small. 

During the financial crisis and ensuing recession, this picture changed dramatically. The Federal Reserve 

made a number of decisions that significantly altered both the size and the composition of its balance 

sheet. For example, the Fed pursued a program of large-scale asset purchases in an effort to increase 

monetary accommodation after it reduced its conventional policy tool, the federal funds rate, to near 

zero. The balance sheet grew from less than $1 trillion to $4.5 trillion. This expansion was achieved, in 

part, through the purchase of large quantities of Treasury securities. 

But in a more unusual step, the Fed also purchased large quantities of non-Treasury securities, altering 

the composition as well as the size of the Fed's balance sheet. In particular, a significant share of the 

purchases was in the form of mortgage-backed securities (MBS), which targeted the housing sector for 

special attention and thus was a form of credit policy in support of a specific sector of the economy. So 

1 This piece was published by the Hoover Institution as part of its Defining Ideas Online Journal, June 10,2017 
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quantitative easing (QE) was a mixture of monetary policy, adding liabilities in the form of bank reserves, 

and credit policy that altered the composition of the assets away from Treasuries toward housing 

securities and MBS in particular. This was an unprecedented market intervention by the Fed. 

More troubling was the lending under Section 13(3) of the Federal Reserve Act (FRA), which included 

support of the creditors of Bear Stearns and AI G. The Fed also funded other lending programs designed 

to support the purchase of commercial paper and other types of asset-backed securities. These credit 

policies were market interventions intended to benefit or subsidize specific parties during the crisis. The 

broader goal was to help stabilize the financial system. Regardless of the rationale, the Fed sold Treasury 

securities from its portfolio and used the proceeds to purchase risky private sector securities. These 

actions amounted to debt-financed fiscal policy but without the explicit authorization of Congress. Given 

the distributional effects of such interventions, it is not surprising they proved controversial. 

A Fed with the power to engage in fiscal policy through such credit allocations faces risks that its 

authority can be abused by political leaders or the Fed itself. The discretion to engage in credit 

allocation represents an open invitation to politicians and interest groups to pressure the central bank 

to use its authority to manage its assets to further some other agenda. Maybe the Fed should invest in 

green energy companies, in domestic manufacturers who pledge not to ship jobs overseas, or 

infrastructure bonds issued by state or municipal authorities. This may seem far-fetched, but Congress 

asked the Fed to invest in the automobile companies in 2008. After all, it had already supported Bear 

Stearns and AIG, and weren't the big four auto companies as important to the economy and 

employment as these financial firms? Fortunately, the Fed said no, but the discretionary authority to 

engage in credit allocation could prove to be a threat to Fed independence. This danger is further 

aggravated by the calls for the Fed to rely on an operating regime that untethers the balance from 

monetary policy. In such a regime, the size of the balance is free to vary while monetary policy is 

determined by the rate of interest on reserves. What a temptation for mischief with the balance sheet 

that could prove to be. 

In response to such criticisms of the scope of Fed authorities, the Dodd-Frank legislation in 2010 

modified lending under Section 13(3) to programs with "broad-based eligibility." Dodd-Frank also 

attempted to devise a resolution regime for large financial institutions so that such rescues by the Fed 

need not arise in the first place. The actions by the Fed that pushed the envelope and scope of Fed 

authorities also have spawned other proposals such as the "audit the Fed" movement and calls for 

changes in Fed governance. These latter proposals, if passed, would strike at the heart of monetary 

policy independence. 

One way to limit the Fed's ability to engage in credit allocation and reduce the incentive for political 

interference is to restrict the central bank to an all-Treasuries portfolio. This would not constrain the 

conduct of monetary policy. There are ample Treasury securities for conducting monetary policy for the 

foreseeable future. The large purchases of MBS were a significant departure from past practice and, as I 

mentioned, were a mixture of both monetary policy (increasing the size of the balance sheet) and credit 

policy (changing the composition of the assets on the balance sheet). The justification of the MBS 
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purchases was not based on the scarcity of Treasuries available for purchase in the open market, but on 

the desire to support housing, which was viewed as important to economic recovery. 

A Treasuries-only policy would prevent the Fed from purchasing private sector assets that would offer 

some firms, sectors, or asset classes preferential treatment and expose the taxpayer to credit risk. It 

would also prevent the Fed from rescues or bailouts of creditors on its own discretionary authority as it 

did during the crisis under Section 13(3). Moreover, it would rule out the discretion of the Fed to acquire 

agency securities and municipal bonds, as well as private securities such as equities and corporate 

bonds. These limitations would strengthen Fed independence by reducing the incentives for political 

interference and lobbying by interested parties. 

Some argue that an all-Treasuries portfolio would limit the ability ofthe Fed to respond to a financial 

crisis. As a lender of last resort, the Fed should focus on the integrity of the payment system. As 

articulated by Walter Bagehot in 1873, the central bank should lend to solvent institutions at a penalty 

rate against good collateral. The Fed's lending to Bear Stearns and AIG were not examples of such 

lending. Instead the Fed lent to failing institutions against questionable collateral. Moreover, the Fed has 

never articulated a strategy for determining who and when such emergency lending was appropriate, or 

defined the collateral requirements. 

It should not be a goal to make bailouts and rescues easy for the Fed, or any other agency for that 

matter. To reduce moral hazard, such options should be eliminated or made very difficult to pursue. 

Section 13(3), even as revised, permits the government to use the Fed's off-budget financial position to 

engage in fiscal actions so the fiscal authorities do not have to step up to the plate. This encourages 

moral hazard, increases risk taking, misplaces decision rights, and undermines accountability. 

A Treasuries-only constraint on the Fed would dramatically curtail its credit policy actions, reduce moral 

hazard, and protect its independence. Yet some argue that the Fed must have the authority to intervene 

in an emergency much as it did in 2008. But this is not necessary. Fiscal policy that puts taxpayer funds 

at risk should be the responsibility of Congress and the U.S. Treasury. It's unnecessary to grant the Fed 

discretionary authority to execute such rescues. If a situation such as Bear Stearns were to arise, the first 

line of defense should be orderly liquidation or bankruptcy. Neither would necessitate a financial role 

for the Fed. 

Nevertheless, it is understandable that many believe that there should be some backstop mechanism for 

the government to act on relative short notice. Emergencies can and do arise. What is needed is a 

mechanism that aligns decision rights and accountability for the fiscal actions being contemplated. 

On several occasions', I have suggested a new accord between the Fed and the Treasury. The idea is to 

specify ex ante the decision rights and accountability for such fiscal decisions during a financial crisis. 

2 https:l/www.philadelphiafed.org/-/media/publications/speeches/plosser/2009/02-27-09 us-monetarv-policyforum.pdf?la=en 

https:l/www. phi ladelphiafed. org/-/media/pu blications/speeches/plosser /2012/02-24-12 us-monetary-policyforum.pdf?la=en 

https://www. philadelphiafed .org/-1 media/publications/ speeches/ plosser /2013/11-13-13 _ cato-i nstitute.pdf?la =en 
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The decision to put taxpayer funds at risk in order to allocate credit differentially across parties or 

sectors lies with the fiscal authorities. The accountability then should also rest with those authorities. 

The role of the Federal Reserve should be limited to helping the Treasury implement the decision. 

Recognizing the appropriate accountability, the Treasury would be required to remove the private 

securities from the Fed's balance sheet in exchange for Treasury securities, thus restoring the allTreasury character of the Fed's balance sheet and ensuring that the fiscal authorities are accountable for 

the risks. 

The framework is easily described: 

1. The Federal Reserve should be required to maintain a Treasuries-only policy as it pertains to the 

conduct of monetary policy. 

2. The Federal Reserve should be prohibited from purchasing non-Treasury securities, private sector 

securities or lending against private collateral except through traditional discount window operations 

with depository institutions. 

3. Emergency lending under Section 13(3) of the FRA should be eliminated and replaced with a new FedTreasury accord, under which the Fed may facilitate, at the Treasury's request, the purchase of private 

sector securities in an emergency. The Treasury would be required to seek Congressional approval for 

such expenditures within 30 days of the action. Upon approval, the Treasury would promptly arrange to 

exchange (at book value) Treasury securities for the private sector securities temporarily acquired by the 

Fed. Should the Congress not approve the action, the Treasury would require the Fed to liquidate such 

securities within 60 days. Any losses or gains incurred by the Fed under such an action would be the 

responsibility of the Treasury. Through these provisions credit policies would cease to be a tool of the 

Federal Reserve and would no longer be a threat to the independence of the Federal Reserve. 

To illustrate how this might work, consider the case of Bear Stearns. 

The decision to support the rescue of Bear Stearns should have been made by the U.S. Treasury. Bear 

Stearns was not a depository institution, nor was it regulated by the Fed. Rather, it was an investment 

bank which had as its primary regulator the SEC. Surely, consultation with the Fed, the SEC, the FDIC, 

and other agencies would be appropriate, but the decision should be that of the fiscal authorities. The 

Fed could help facilitate that decision and be instructed by the Treasury to acquire whatever securities 

required to implement the decision. But it is important that the decision rights rest with the Treasury, 

with the Fed as the facilitator operating under the instructions of the Treasury. 

In this case, the transaction could have proceeded as it did. The Fed facilitated the purchase of Bear 

Stearns by JP Morgan by, in effect, purchasing (raising cash by selling Treasuries from its portfolio) 

approximately $29 billion of high risk private assets. These risky assets were placed in an LLC wholly 

owned by the New York Fed, named Maiden Lane. 

Then comes the important part. The Treasury would then be required, within 30 days, to get an approval 

or appropriation by Congress. Following approval, the Treasury would arrange an exchange of those 
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private assets purchased by the Fed for Treasury securities. For example, the Treasury could simply issue 

debt in the amount of the book value of the Maiden Lane assets and deposit the proceeds at the Fed in 

exchange for the ownership of Maiden Lane assets. The Fed would then use the proceeds to purchase 

Treasuries in the secondary market. At the conclusion of such an exchange, the Fed's portfolio would be 

returned to where it was before the transaction, the U.S. Treasury would be the owners of the Maiden 

Lane assets, and accountability for the decision would rest with the appropriate decision-making 

authority. Any gains or losses on the ultimate disposition of the securities would then accrue to the 

Treasury and the taxpayer. 

Requiring the Federal Reserve to maintain an all-Treasuries portfolio would address several issues. It 

would protect its independence; reduce its discretionary authorities; and return fiscal authority and 

credit allocation to Congress and the U.S. Treasury. 

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