Kevin Warsh: An ode to independence
Speech by Mr Kevin Warsh, Member of the Board of Governors of the Federal Reserve
System, at the Shadow Open Market Committee, New York, 26 March 2010.
* * *
Thank you for welcoming me to a meeting of the Shadow Open Market Committee.1
The overall profitability and balance sheet strength of large U.S. enterprises is impressive at
this stage of recovery. Equity prices and credit terms in liquid markets corroborate these
improved fundamentals. And for these firms, financial market conditions appear quite
supportive of economic growth.
Still, significant economic challenges persist. While recent trends in personal consumption
and business investment trends are positive, the underlying strength of the economy over the
medium term is less clear. Unemployment remains high, and stubbornly so. Small and
medium-sized enterprises, which have tended to lead recoveries, are still hesitant to expand -
revenue growth is tepid, costs are uncertain, and credit conditions remain more difficult than
for large firms.
Increases in government expenditures around the world - ostensibly instituted as a bulwark
against further economic weakness - are raising fiscal deficits significantly. Unsustainable,
projected fiscal debt loads - including large and growing implicit guarantees bestowed upon
large financial firms by governments - are raising concerns in sovereign debt markets.
Taking account of the broad range of economic and financial conditions, there is no wonder
that the electorate - in the United States and abroad - is unnerved. The uncomfortable
juxtaposition of financial and economic realities has caused some fundamental precepts of
the so-called Anglo-American economic model to be attacked.
Allow me to join your discussion on an increasingly questioned foundation of our economic
system, the independent status of central banks.
Institutional credibility at stake
Monetary accommodation from the world's largest central banks remains extraordinary.
Policy decisions made in response to the global financial crisis resulted in dramatic changes
in the size and composition of central bank balance sheets. The Federal Reserve's balance
sheet has nearly tripled, including about $1.2 trillion of new mortgage-related securities,
matched by a rise in excess reserve balances.
Yet, the Federal Reserve's most significant asset, like many other central banks, is not on its
swollen balance sheet. Neither can it be found in the lengthy footnotes of its audited financial
statements. Nor is it tucked away in the recesses of the Federal Reserve Act, like the
longdormant, now renowned, section 13(3).
The Fed's greatest asset is its institutional credibility. This institutional credibility is rooted in
its inflation-fighting credibility, but it is broader still.2 It is tied up in the full range of Fed
actions and balance sheet commitments. This credibility is essential. It increases the heft of
our communications. It gives weight to our economic assessments. It amplifies the effect of
announced changes in the short-term policy rate on longer-term rates. It is, in some sense,
the real money multiplier in the conduct of policy.
Given its immense value, we should not forget that the Federal Reserve's hard-earned
credibility is no birthright. It is as much nurture as nature. It was earned by our predecessors
in the conduct of their duties, making considered judgments consistent with the statutory
mandate of price stability and maximum employment. Fortunately, for the asset to be
burnished and bestowed upon the current crop of central bankers, it did not demand perfect
clairvoyance or infallible judgments. But it did require fierce independence from the whims of
Washington and the wants of Wall Street, and from a pernicious short-termism that can
undermine the proper conduct of policy. This fierce independence is needed, perhaps now
more than ever.
Central bank independence is precious. It can be taken for granted in benign times, but it is
tested when times get tough. And we still have tough times ahead of us. My colleagues and I
must demonstrate that Fed independence has not been relegated, and the Fed's long-term
objectives not compromised. Ensuring Fed independence - as the cornerstone of
institutional credibility - is our charge to keep. It is central to what the Federal Reserve
represents, and to how policy is conducted.
The mantra of Fed independence is not some throw-away line that seeks to absolve the
central bank of accountability. To the contrary, institutional credibility demands transparency
so that the Fed's performance of its responsibilities can be judged on the merits.
But, the call for central bank independence can be misunderstood, its defense misconstrued,
its threats dismissed, and the consequences of its breach underestimated. In the balance of
my remarks, I will discuss these issues.
Central bank actions at the water's edge
The Congress is currently immersed in a significant policy debate on the role of the central
bank, as part of legislation described by its authors as comprehensive, fundamental
regulatory reform.3 And it is worth remembering that the Federal Reserve is the nation's third
significant experiment with a central bank.4 As the Federal Reserve nears its centennial, the
Fed's longevity should not allow our memories to fail us on its origin and the scope of its
remit. Let me explain.
The grant of authority to the central bank is a considered judgment of the nation's elected
representatives. Central bankers are entrusted with a revocable privilege. So, declarations of
independence by Fed policymakers are heartening. But independence is ours to
demonstrate, not principally to declare. And central bankers err if they presume that
independence is some inalienable right, some entitlement.
A misconception on the nature of the central bank's authority gives succor to Fed critics. The
Fed is not independent from government. It is independent within government. And elected
representatives have every right to redraw the central bank's authority, even if a fuller
reading of economic history considers it unwise.
The Federal Reserve's defenders also err if they seek to extend the Fed's vaunted
independence to the full range of its activities. My reading has it that the Congress granted
the Fed independence in the conduct of monetary policy. In my view, no particular deference
is owed - no promise of non-intervention due - in the conduct of regulatory policy, consumer
protection, or other responsibilities granted to the Federal Reserve. This sharp distinction
should be sustained as the Congress considers revisions to the Federal Reserve's charter.
So, delineating that which constitutes the conduct of monetary policy - as distinct from these
other activities - is critical. In normal times, there is less confusion. The Fed establishes
shortterm, risk-free interest rates across the economy. And it does its level best to signal the
appropriate path of policy to ensure low and stable prices and maximum employment over the
horizon. The Fed's lender of last resort authority manifests itself - usually only sparingly - in
the operation of the discount window, lending against good collateral at a penalty rate.
In times of more significant economic and financial distress, the pace of monetary
accommodation often increases. And when liquidity becomes scarce - as was the case
during the Panic of 2008 - the Fed finds itself charged with more novel and significant
challenges in providing liquidity to institutions and markets.5
History teaches us that fiscal and monetary policies tend to blur in these times of crisis.
Capital and liquidity issues become difficult to disentangle at troubled institutions.6 Capital
offsets losses. Liquidity bridges gaps in funding. And well-intentioned policymakers are
compelled to make tough judgments amid significant time constraints. What constitutes an
emergency liquidity provision backed by good collateral at a penalty price? And what is more
aptly characterized as a fiscal provision to bolster capital?
The Federal Reserve must do its utmost to stay foursquare within its role as liquidity
provider. The Fed's financial stability responsibilities, which may well be elevated in pending
legislation, should not give license to central bankers to be emergency capital providers.
Capital allocations should reside, if anywhere, with the fiscal authority and its fiscal agent, the
Department of Treasury.
The Fed, as first-responder, must strongly resist the temptation to be the ultimate rescuer.
No matter the congressional calendar or the pleadings of the elected, the Fed is not a repair
shop for broken statutes or broken financial ecosystems.7 And it should not be an appeals
court to those seeking relief from congressional appropriators or the fiscal agents at the
Treasury. The Fed's credibility is severely undermined if it is perceived to wander from its
mission into areas more appropriately handled by other parts of government.
The Panic of 2008 is now prologue. The Fed's actions going forward - especially when
economic conditions still appear unsatisfactory - should go a long way to demonstrating its
allegiance to mission. There will no doubt be added pressures for policy makers to aid and
comfort the aggrieved. That help should be forthcoming does not address the question as to
whether it is the institutional prerogative of the Fed to provide it. Even if the central bank can
does not mean the central bank should.
Other threats to independence and credibility
There is no such thing as being a little bit independent or a little bit credible.
So, central bankers must be constantly vigilant, especially during times of fiscal expansion.
Net global debt issuance in 2010 may be three to four times the average of the prior
decade.8 Ratios of government debt to gross domestic product are growing rapidly among
advanced economies. As I just discussed, the Fed should steer clear of fiscal policy. But, the
threats to independence do not stop there. In this environment, let me briefly comment on
two other pressure points. And note that not all of the threats to central bank independence
come from outside the walls of the Federal Reserve. Some pressures, however
wellintentioned, like in the clichéd scary movie, may come from inside the house.
First, governments may be tempted to influence the central bank to keep monetary policy
looser longer to finance the debt and stimulate activity. In the more static short-run, the real
burdens of nominal debt could be reduced by higher inflation. The consequences just over
the horizon, however, would be most unwelcome. Higher expected inflation would lead to
higher nominal interest rates, increasing the financing needs of the government yet further.
Moreover, higher expected inflation could lead to more variable inflation outcomes and
reduced living standards, especially for those least able to protect themselves from
unexpected price movements.9
Central banks must take their own counsel when deciding upon the timing and force in
removing monetary policy accommodation. I am confident that any attempt to influence
inappropriately the conduct of Fed policy would yield a strong and forceful rebuke by Fed
officials and market participants alike. The only popularity central bankers should seek, if at
all, is in the history books.
The second threat, in this case to central bank credibility, may be better intentioned, but it is
no less risky. Some suggest that central bankers themselves should choose to modify their
definitions of price stability. If inflation persisted at higher levels during normal times, the
theory goes, central bankers could cut rates more substantially in response to economic
weakness. The theory, in my view, fails the real test of experience.
Central banks that desire just a little more inflation may well end up with a lot more. Some
point to a strategy to accept a little more inflation for less unemployment as a primary basis
for the great inflation of the 1970s in the United States.10 By definition, an increase in an
implicit inflation target would lead to an upward shift in inflation expectations. And how would
a central bank make credible its promise that such a shift would be only a one-time event?
We do not understand sufficiently the determinants of inflation expectations to be confident
that a regime change can be controlled. Central banks, here and abroad, have worked for
decades to get inflation down to levels consistent with price stability. We should not risk
these hard-won gains. In changing the goal posts at this time of consequence, substantial
harm would be done to a central bank's institutional credibility, and perhaps lead to an
unmooring of inflation expectations. Such damage could lead investors to seek alternative
currencies, with prices of commodities and other hard assets likely to increase.
Conclusion
Independence in the conduct of monetary policy is at the core of advanced modern
economies. And it can be too easily forgotten by those who have only known its benefits. If
the Federal Reserve lost its independence, its hard-earned credibility would quickly dissipate.
The costs to the economy would be incalculable: Higher inflation, lower standards of living,
and a currency that risks losing its reserve status.
Now more than ever, market participants are watching the relationship between central
banks and their governments. They are keenly gauging whether changes in conditions,
policies, or practices pierce the veil of central bank independence. Central bankers the world
over must demonstrate that we are worthy of this moment, and will be steadfast protectors of
our institutions' credibility. That means respecting our important but circumscribed role in the
conduct of policy, and performing our mission with competence and consistency.