Donald L Kohn: Federal Reserve independence
Testimony by Mr Donald L Kohn, Vice Chairman of the Board of Governors of the US
Federal Reserve System, before the Subcommittee on Domestic Monetary Policy and
Technology, Committee on Financial Services, US House of Representatives, Washington
DC, 9 July 2009.
* * *
Chairman Watt, Ranking Member Paul, and other members of the Subcommittee, I
appreciate the opportunity to discuss with you the important public policy reasons why the
Congress has long given the Federal Reserve a substantial degree of independence to
conduct monetary policy while ensuring that we remain accountable to the Congress and to
the American people. In addition, I will explain why an extension of the Federal Reserve's
supervisory and regulatory responsibilities as part of a broader initiative to address systemic
risks would be compatible with the pursuit of our statutory monetary policy objectives. I also
will discuss the significant steps the Federal Reserve has taken recently to improve our
transparency and maintain accountability.
Independence and accountability
A well-designed framework for monetary policy includes a careful balance between
independence and accountability. A balance of this type conforms to our general inclination
as a nation to have clearly drawn lines of authority, limited powers, and appropriate checks
and balances within our government; such a balance also is conducive to sound monetary
policy.
The Federal Reserve derives much of the authority under which it operates from the Federal
Reserve Act. The act specifies and limits the Federal Reserve's powers. In 1977, the
Congress amended the act by establishing maximum employment and price stability as our
monetary policy objectives; the Federal Reserve has no authority to establish different
objectives. At the same time, the Congress has - correctly, in my view - given the Federal
Reserve considerable scope to design and implement the best approaches to achieving
those statutory objectives. Moreover, as I will discuss in detail later, the independence that is
granted to the Federal Reserve is subject to a well-calibrated system of checks and balances
in the form of transparency and accountability to the public and the Congress.
The latitude for the Federal Reserve to pursue its statutory objectives is expressed in several
important ways. For example, the Congress determined that Federal Reserve policymakers
cannot be removed from their positions merely because others in the government disagree
with their views on policy issues. In addition, to guard against indirect pressures, the Federal
Reserve determines its budget and staff, subject to congressional oversight. Thus, the
system has three essential components: broad objectives set by the Congress,
independence to pursue those legislated objectives as efficiently and effectively as possible,
and accountability to the Congress through a range of vehicles.
Benefits of independence to conduct policy in pursuit of legislated objectives
The insulation from short-term political pressures - within a framework of legislated
objectives and accountability and transparency - that the Congress has established for the
Federal Reserve has come to be widely emulated around the world. Considerable
experience shows that this type of approach tends to yield a monetary policy that best
promotes economic growth and price stability. Operational independence - that is,
independence to pursue legislated goals - reduces the odds on two types of policy errors
that result in inflation and economic instability. First, it prevents governments from
succumbing to the temptation to use the central bank to fund budget deficits. Second, it
enables policymakers to look beyond the short term as they weigh the effects of their
monetary policy actions on price stability and employment.
History provides numerous examples of non-independent central banks being forced to
finance large government budget deficits. Such episodes invariably lead to high inflation.
Given the current outlook for large federal budget deficits in the United States, this
consideration is especially important. Any substantial erosion of the Federal Reserve's
monetary independence likely would lead to higher long-term interest rates as investors
begin to fear future inflation. Moreover, the bond rating agencies view operational
independence of a country's central bank as an important factor in determining sovereign
credit ratings, suggesting that a threat to the Federal Reserve's independence could lower
the Treasury's debt rating and thus raise its cost of borrowing.1 Higher long-term interest
rates would further increase the burden of the national debt on current and future
generations.2
The second way in which political interference with monetary policy can damage the
economy is by promoting an undue focus on the short term. Because excessively easy
monetary policy tends to boost economic activity temporarily before the destabilizing effects
of higher inflation are felt, policymakers with a relatively short-term outlook may be tempted
to ease monetary policy too much. The eventual result is higher inflation without any
permanent benefit in terms of employment, an outcome that is inconsistent with the dual
mandate for maximum employment and price stability. Thus the increase in inflation must be
followed by policies to bring inflation back down - policies that have the side effect of
temporarily reducing output and employment. The fixed, lengthy, and overlapping terms of
Federal Reserve Board members, in combination with the other elements of operational
independence, help ensure that the Federal Reserve appropriately considers both the
shortterm and long-term effects of its policy decisions.
Statistical studies have confirmed that countries with more independent central banks
experience lower and more stable rates of inflation with no sacrifice of jobs or income.3
Moreover, low and stable rates of inflation help to deliver strong economic growth and high
rates of employment. The benefits of central bank independence appear to be a major
explanation for the trend I mentioned earlier of countries moving to establish or to enhance
the independence of their central banks. It is surely no coincidence that countries around the
world have experienced sustained declines in the level and variability of inflation as they
have moved to grant their central banks greater operational independence.
Monetary policy independence and the mitigation of systemic risk
Is monetary policy independence threatened by giving a central bank other responsibilities,
such as supervisory and regulatory authority for some parts of the financial system? Are
1
Standard & Poor's (2004), "Sovereign Credit Ratings: A Primer," March 15,
www2.standardandpoors.com/spf/pdf/products/SovRatingsPrimer_sov.pdf.
2
The beneficial effects of central bank independence on a government's borrowing costs have been observed
even when budget deficits are not unusually large. For example, on May 6, 1997, the U.K. government
announced that the Bank of England would be given considerable operational independence. The yield on
10year U.K. government bonds fell 30 basis points that day, even though the government made no change to
the Bank of England's policy objectives and there was no other prominent economic or policy news. Market
participants widely attributed the decline in long-term interest rates to the surprise announcement of
independence and the consequent increased confidence in future price stability.
3
See, for example, the survey in Alex Cukierman (2008), "Central Bank Independence and Monetary
Policymaking Institutions - Past, Present, and Future," European Journal of Political Economy, vol. 24
(December), pp. 722-36.
BIS Review 87/2009
there potential conflicts between a high degree of independence for monetary policy and
accountability in supervisory and regulatory policy? I believe that U.S. and foreign experience
shows that monetary policy independence and supervisory and regulatory authority are
mutually compatible and even have beneficial synergies.
The current financial crisis has clearly demonstrated the need for the United States to have a
comprehensive and multifaceted approach to containing systemic risk. The Administration
recently released a proposal for strengthening the financial system that would provide new or
enhanced responsibilities to a number of federal agencies, including the Securities and
Exchange Commission (SEC) and the Commodity Futures Trading Commission with respect
to over-the-counter derivatives, the SEC with respect to hedge funds and their advisers, and
several agencies, including the Treasury, the Federal Deposit Insurance Corporation, the
Federal Reserve Board, and the SEC with respect to the resolution of systemically important
failing nonbank financial institutions. In addition, the proposal would provide the Federal
Reserve certain new responsibilities for overseeing systemically important financial
institutions and payment, clearing, and settlement arrangements.
These incremental new responsibilities are a natural outgrowth of the Federal Reserve's
existing supervisory and regulatory responsibilities. Through our role as consolidated
supervisor of all bank holding companies (BHCs), the Federal Reserve has long been
responsible for supervising many of the most important U.S. financial organizations, and in
the current crisis several more large complex financial firms - including Goldman Sachs,
Morgan Stanley, and American Express - have become bank holding companies. And the
expanded regulatory authority of the Federal Reserve with respect to payment and
settlement systems builds upon our existing responsibilities for supervising certain critical
payment, clearing, and settlement systems, such as the Depository Trust Company and CLS
Bank, as well as our historical efforts to reduce risk in such systems through, for example,
our Payment System Risk Policy.4
The authorities that the Administration's proposal would provide the Federal Reserve with
respect to systemically important non-BHC financial firms and payment, clearing and
settlement systems also are similar in many respects to the authorities that the Federal
Reserve currently has with respect to bank holding companies and payment, clearing, and
settlement systems under our supervision. The Administration's proposal does call for a
more macro-prudential approach to the supervision and regulation of systemically important
financial firms and payment, clearing, and settlement systems, including the establishment of
higher capital, liquidity, and risk-management requirements for systemically important firms.
The Federal Reserve already has been moving to incorporate a more macro-prudential
approach to our supervisory and regulatory programs, as evidenced by the recently
completed Supervisory Capital Assessment Program. The Federal Reserve has also long
been a leader in the development of strong international risk-management standards for
payment, clearing, and settlement systems and has implemented these standards for the
systems it supervises.
In our supervision of bank holding companies and our oversight of some payment systems,
we already work closely with other federal and state agencies and participate in groups of
regulators and supervisors such as the Federal Financial Institutions Examination Council
and the President's Working Group on Financial Markets. These responsibilities and close
working relationships have not impinged on our monetary policy independence, and we do
not believe that the enhancements proposed by the Administration to the Federal Reserve's
supervisory and regulatory authority would undermine the Federal Reserve's ability to pursue
our monetary policy objectives effectively and independently.
Indeed, these enhancements would complement the Federal Reserve's monetary policy
responsibilities. The Federal Reserve and other central banks have always been involved in
issues of systemic risk, most notably because central banks act as lenders of last resort.
Central banks, which operate in markets daily and have macroeconomic responsibilities,
bring a broad and unique perspective to analysis of developments in the financial system.
And, as we have seen over the past two years, threats to the stability of the financial system
can have major implications for employment and price stability. Thus, the Federal Reserve's
monetary policy objectives are closely aligned with those of minimizing systemic risk. To the
extent that the proposed new regulatory framework would contribute to greater financial
stability, it should improve the ability of monetary policy to achieve maximum employment
and stable prices.
Accountability and transparency
In a democracy, any significant degree of independence by a government agency must be
accompanied by substantial accountability and transparency. The Congress and the Federal
Reserve have established a number of policies and procedures to ensure that the Federal
Reserve continues to use its operational independence in a manner that promotes the
nation's well-being. The Federal Reserve reports on its experience toward achieving its
statutory objectives in the semiannual Monetary Policy Reports and associated
congressional testimony. The Federal Open Market Committee (FOMC) releases a
statement immediately after each regularly scheduled meeting and detailed minutes of each
meeting on a timely basis. We also publish summaries of the economic forecasts of FOMC
participants four times a year. In addition, Federal Reserve officials frequently testify before
the Congress and deliver speeches to the public on a wide range of topics, including
economic and financial conditions and monetary and regulatory policy.
Our financial controls are examined by an external auditor, and Reserve Bank operations
and controls are reviewed by each Reserve Bank's independent internal audit function and
by Board staff who oversee Reserve Bank activities. We provide the public and the Congress
with detailed annual reports on the consolidated financial activities of the Federal Reserve
System that are audited by an independent public accounting firm. We also publish a
detailed balance sheet on a weekly basis.
The Federal Reserve recognizes that the new programs we have instituted to combat the
financial crisis must be accompanied by additional transparency. Americans have a right to
know how the Federal Reserve is using taxpayer resources and they need to be assured that
we are acting in a responsible manner that minimizes risk and maintains the integrity of our
operations. We have increased the transparency of our actions while safeguarding our ability
to achieve our public policy goals of fostering financial and economic stability. This year we
expanded our website to include considerable background information on our financial
condition and our policy programs. Recently, we initiated a monthly report to the Congress
and the public on Federal Reserve liquidity programs that provides even more information on
our lending, the associated collateral, and other facets of programs established to address
the financial crisis. These steps should help the public understand the considerable efforts
we have taken to minimize the risk of loss as we provide liquidity to the financial system in
our role as lender of last resort. Altogether, we now provide a higher degree of transparency
than at any other time in the history of the Federal Reserve System. Because of the large
volume of information we publish, the Federal Reserve is among the most transparent
central banks in the world.
Federal Reserve policymakers are highly accountable and answerable to the government of
the United States and to the American people. The seven members of the Board of
Governors of the Federal Reserve System are appointed by the President and confirmed by
the Senate after a thorough process of public examination. The key positions of Chairman
and Vice Chairman are subject to presidential and congressional review every four years, a
separate and shorter schedule than the 14-year terms of Board members. The members of
the Board of Governors account for seven seats on the FOMC. By statute, the other five
members of the FOMC are drawn from the presidents of the 12 Federal Reserve Banks.
District presidents are appointed through a process involving a broad search of qualified
individuals by local boards of directors; the choice must then be approved by the Board of
Governors. In creating the Federal Reserve System, the Congress combined a
Washingtonbased Board with strong regional representation to carefully balance the variety of interests
of a diverse nation. The Federal Reserve Banks strengthen our policy deliberations by
bringing real-time information about the economy from their district contacts and by their
diverse perspectives.
Oversight by the Government Accountability Office
On the topic of Federal Reserve accountability and transparency, the possibility of expanding
the audit authority of the Government Accountability Office (GAO) over the Federal Reserve
has recently been discussed. As you know, the Federal Reserve is subject to frequent audits
by the GAO on a broad range of our functions.
For example, the supervisory and regulatory functions of the Federal Reserve are subject to
audit by the GAO to the same extent as the supervisory and regulatory functions of the other
federal banking agencies. Thus, the GAO has full authority to - and does in fact - audit the
manner in which the Federal Reserve supervises and regulates bank holding companies on
a consolidated basis. Moreover, if the Congress were to provide the Federal Reserve with
responsibility for serving as the consolidated supervisor of systemically important financial
firms that are not bank holding companies, the GAO would, under existing law, have full
authority to audit the Federal Reserve's supervision and regulation of such firms as well. We
would expect the GAO to actively use that authority, as it does today. Indeed, as of June 29,
2009, the GAO had 19 engagements under way involving the Federal Reserve, including 14
that were initiated at the request of the Congress. In addition, since the beginning of 2008,
the GAO has completed 26 engagements involving the Federal Reserve, including
engagements related to the Basel II capital framework, risk-management oversight, the Bank
Secrecy Act, and the Board's Regulation B, which implements the Equal Credit Opportunity
Act.
The Congress also recently clarified the GAO's ability to audit the Term Asset-Backed
Securities Loan Facility (TALF), a joint Treasury-Federal Reserve initiative, in conjunction
with the GAO's reviews of the performance of Treasury's Troubled Asset Relief Program
(TARP). The Federal Reserve has been working closely with the GAO to provide that agency
with access to information and personnel to permit it to fully understand the terms,
conditions, and operations of the TALF so that the TARP can be properly audited. At the
same time, the Congress granted the GAO new authority to conduct audits of the credit
facilities extended by the Federal Reserve to "single and specific" companies under the
authority provided by section 13(3) of the Federal Reserve Act, including the loan facilities
provided to, or created for, American International Group and Bear Stearns. These facilities
are markedly different from the widely available credit facilities - such as the discount
window access for depository institutions, the Primary Dealer Credit Facility, and the
Commercial Paper Funding Facility - that the Federal Reserve either has historically used or
has recently established to address broad credit and liquidity issues in the financial system.
For this reason, the Federal Reserve did not object to granting the GAO audit authority over
these institution-specific, emergency credit facilities.
The Congress, however, has purposefully - and for good reason - excluded from the scope
of potential GAO audits monetary policy deliberations and operations, including open market
and discount window operations, and transactions with or for foreign central banks, foreign
governments, and public international financing organizations. By excluding these areas, the
Congress has carefully balanced the need for public accountability with the strong public
policy benefits that flow from maintaining the independence of the central bank's monetary
policy functions and avoiding disruption to the nation's foreign and international relationships.
The same public policy reasons that supported the creation of these exclusions in 1978
remain valid today. The Federal Reserve strongly believes that removing the statutory limits
on GAO audits of monetary policy matters would be contrary to the public interest by tending
to undermine the independence and efficacy of monetary policy in several ways. First, the
GAO serves as the investigative arm of the Congress and, by law, must conduct an
investigation and prepare a report whenever requested by the House or Senate or a
committee with jurisdiction of either body. Through its investigations and audits, the GAO
typically makes its own judgments about policy actions and the manner in which they are
implemented, as well as recommendations to the audited agency and to the Congress for
changes or future actions. Accordingly, financial markets likely would see the grant of audit
authority with respect to monetary policy to the GAO as undermining monetary
independence - with the adverse consequences discussed previously - particularly because
GAO audits, or the threat of a GAO audit, could be used to try to influence monetary policy
decisions.
Permitting GAO audits of monetary policy also could cast a chill on monetary policy
deliberations through another channel. Although Federal Reserve officials regularly explain
the rationale for their policy decisions in public venues, the process of vetting ideas and
proposals, many of which are never incorporated into policy decisions, could suffer from the
threat of public disclosure. If policymakers believed that GAO audits would result in published
analyses of their policy discussions, they might be less willing to engage in the unfettered
and wide-ranging internal debates that are essential to identifying the best possible policy
options. Moreover, the publication of the results of GAO audits related to monetary policy
actions and deliberations could complicate and interfere with the communication of the
FOMC's intentions regarding monetary policy to financial markets and the public more
broadly. Households, firms, and financial market participants might be uncertain about the
implications of the GAO's findings for future decisions of the FOMC, thereby increasing
market volatility and weakening the ability of monetary policy actions to achieve their desired
effects.
These concerns extend to the policy decisions to implement the discount window and
broadly available credit facilities. These facilities are extensions of our responsibility for
promoting financial stability, maximum employment and price stability. Indeed, unlike the
institution-specific loans that the Federal Reserve has made that now are subject to GAO
audit, these broader market facilities are designed to unfreeze financial markets and lower
interest rate spreads in concert with our other monetary policy actions. It is important that,
like other monetary policy decisions, the Federal Reserve remain independent in making
policy decisions regarding these facilities.
An additional concern is that permitting GAO audits of the broad liquidity facilities the Federal
Reserve uses to affect credit conditions could reduce the effectiveness of these facilities in
helping promote financial stability, maximum employment, and price stability. For example,
even if strong confidentiality restrictions were established, individual banks might be more
reluctant to borrow from the discount window if they knew that their identity and other
sensitive information about their borrowings could be disclosed to the GAO. Rumors that a
bank may have used the discount window can cause a damaging loss of confidence even to
a fundamentally sound institution. Experience, including experience in the current financial
crisis, shows that banks' unwillingness to use the discount window can result in high and
volatile short-term interest rates and limit the effectiveness of the discount window as a tool
to enhance financial stability.
Overall, the Federal Reserve believes that removing the remaining statutory limits on GAO
audits of monetary policy and discount window functions would tend to undermine public and
investor confidence in monetary policy by raising concerns that monetary policy judgments in
pursuit of our legislated objectives would become subject to political considerations. As a
result, such an action would increase inflation fears and market interest rates and, ultimately,
damage economic stability and job creation.
Thank you for inviting me to present the Board's views on this very important subject. I look
forward to answering any questions you may have.