How the Federal Reserve Can Maintain Its Independence

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Wharton's David Zaring and MSU's Lisa Cook discuss the future of the Federal Reserve.

Federal Reserve chair Janet Yellen is facing a delicate balancing act amid pressure from the Trump administration that some feel could undermine the Fed’s independence, even as she may be willing to concede some ground in reviewing financial regulations.

In testimony to Congress on February 14 and 15, Yellen gave no major hints about a possible interest rate increase at the next Federal Open Market Committee (FOMC) meeting on March 14-15. She did say that she expects “the evolution of the economy to warrant further gradual increases in the federal funds rate,” as “waiting too long to remove accommodation would be unwise.” However, she made it clear that “monetary policy is not on a preset course” and economic data would guide future rate actions.

“One thing that is not clear from statements [President Donald Trump] has made in the past is that he understands what independence of the institutions means — whether it is the judiciary or the Federal Reserve,” said Lisa Cook, professor of economics and international relations at Michigan State University. “We absolutely have to guard this independence. That is what has gotten us out of the recession — let’s be clear — because Congress abdicated its responsibility for fiscal stimulus. The Fed has been doing all the heavy lifting getting us out of the recession.”

Rumors of Yellen’s departure from her office before her term ends in 2018, which Yellen herself has denied, have raised concerns over Trump’s ability to influence monetary policy and regulation in the long run. Irrespective of what Yellen decides, Trump will get to have his way in other places in the monetary policy-making and regulatory establishment, according to David Zaring, Wharton professor of legal studies and business ethics. “Even if she doesn’t [leave], the President is going to have a real chance to remake the Fed,” he said.

Zaring pointed to the need to replace Daniel Tarullo, a Federal Reserve board member who is widely credited with leading financial regulation after the 2008 recession. Tarullo resigned last week, but will stay on until early April. That means Trump must fill a total of three vacancies on the Fed’s Board of Governors. Like Yellen, Fed vice chair Stanley Fischer also completes his term in 2018. Similarly, three of five commissioner spots are vacant at the Securities and Exchange Commission, following the voluntary departure on January 20 of chairwoman Mary Jo White. Many heads of divisions at that agency have also quit, Zaring said. “So there is a lot of work to be done in re-staffing financial regulators. And staffing choices really can make a huge difference.”

Cook and Zaring discussed the emerging contours of the Fed’s independence, interest rates and financial regulation on the Knowledge@Wharton show on Wharton Business Radio on SiriusXM channel 111. (Listen to the podcast at the top of this page.)

Whither Interest Rates?

The most immediate speculation is over how Yellen and the FOMC will act on interest rates. “[Yellen] was as cautious as she has been and can be,” Cook said of the Fed chair’s congressional testimony. “They have three quarter-point rate hikes that are penciled in. She is in no hurry for those hikes to proceed if the data are not there, especially with respect to increased uncertainty in the economic data.” That data would cover the period after the presidential inauguration “or since some of these policies have been introduced or at least alluded to,” she added, underlining the direct impact of the Trump administration on economic growth. “A lot of uncertainty has been introduced, and this will make all of the members of the FOMC be more cautious.” However, Cook noted that a third of the economists who have been surveyed “suggest that there will be a rate hike in March.”

“Even if [Yellen] doesn’t [leave], the President is going to have a real chance to remake the Fed.”–David Zaring

Wharton finance professor Krista Schwarz also agreed with Yellen’s cautious approach to raising rates. “Many have been arguing for a long time that the Fed has set rates too low,” she said. Schwarz, who previously worked for the Fed, pointed out that inflation is “still too low” and the economy seems to be “very close” to full employment. She predicted that the Fed “will pick up the pace of tightening a little bit this year” while Yellen monitors economic data. “But they will not raise rates sharply unless and until they actually see signs of an inflationary problem in hard data.”

Schwarz said the shifting positions of advocates of higher interest rates make a decision more difficult. “Those arguing for much higher rates seem to constantly change the rationale,” she explained. “Sometimes it is inflation, sometimes it is financial stability, sometimes it is fiscal policy, and sometimes it is just [about] wanting banks to be more profitable. The morphing rationale brings these arguments into even greater question.”

Easing Cash Flows

In her testimony, Yellen rejected the idea that excessive regulation has hampered bank lending. “I see well-capitalized banks that are regarded as safe, strong and sound,” and they are “capturing market share,” she told the Senate Banking Committee earlier this week. Zaring said many in the political establishment do not share that view, and referred to Massachusetts Sen. Elizabeth Warren’s comment that banks aren’t lending enough and that it is hurting small businesses. Also, corporate America and Wall Street are complaining that it is hard to obtain financing in the bond market, he noted. “All of these people suggest that credit is difficult,” he said. “It is interesting to see the Fed say that they don’t seem to agree, or Janet Yellen isn’t willing to go there.”

Such complaints about lending are not new, said Cook. “Banks always say they could use more money and firms always say they could use more money,” she said, referring to her surveys of banks and firms over the past two or three decades.

“A central bank’s independence is the cornerstone of its ability to execute effective monetary policy.”–Krista Schwarz

Cook pointed to payment delays as a serious factor that causes a liquidity crunch for small businesses, and she called for some form of government intervention to unclog those pipelines. She recalled that during 2011-2012, suppliers were slowing down payments to small businesses. “This kind of cash crunch can have a significant effect on a small business,” she said. “That’s a margin along which there can be some action — some sort of governmental intervention.” She said the government could ensure that small businesses that are government contractors are paid in a more timely fashion. The objective should be to get payments made within 30 days, “but veering away from what was creeping up to be 180 days for many suppliers.”

Small businesses do not have the cash flow to accommodate payments that are held up for 180 days or longer, Cook said. She recalled that during the last government shutdown (in September-October 2013), providers of government services that were privatized didn’t get paid because there was no work during that time period. Some of those people missed mortgage payments, and applying for unemployment benefits takes time, she noted. “Small [financial troubles] can have very big effects on individuals, on families and on small businesses,” she said. “Often, families, individuals and small businesses are interconnected, so there is something that we could do [for them], especially with government contractors.”

Areas of Agreement

Janet Yellen had to “toe a difficult line,” said Zaring, referring to her willingness to review financial regulations, even as she disagreed with attacks on the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act. “She feels that Dodd-Frank is working and that it shouldn’t be repealed or re-jiggered in the way that the President and his treasury secretary suggested is appropriate.”

Meanwhile, the Fed is not taking a hard line on regulation, Zaring noted. He referred, for example, to Yellen suggesting in her testimony that Congress might want to consider exempting some smaller community banks from the Volcker Rule (which sought to prohibit banks from making speculative investments that do not benefit their customers). “[Then], maybe those smaller banks are more receptive and likely to help out small businesses with the financing they need,” he said.

According to Schwarz, a full-blown repeal of Dodd-Frank is unlikely, but parts of it may well be amended by Congress. In any event, she said the executive branch of the new administration “is clearly going to take a much softer line on financial regulation.”

Retaining the Fed’s Independence

Schwarz said the continued independence of the Fed is a looming concern. “We are in the early days of the new administration, and the noise-to-signal ratio of news in this regard is high at present,” she said. “But, some of the bills that have been proposed in Congress and some of the statements made by Trump on the campaign trail could indeed raise worries about Fed independence if these were to become a more clear course of policy.”

Schwarz explained why the Fed’s independence is critical. “A central bank’s independence is the cornerstone of its ability to execute effective monetary policy,” she said. “A lack of independence confers a lack of credibility in the institution’s policy motives. An infringement on the Fed’s independence would be a very bad outcome. Credibility is crucial to anchoring inflation expectations and guiding investment and savings decisions in the economy.”

Cook said that while the White House and the Federal Reserve communicate with each other during “times of crisis,” or even during normal times, there is no congressionally mandated requirement for the Fed chair to make presentations to the President. However, the Fed chair is required to make periodic presentations to Congress, she added.

That said, how Fed chairs have related to the President has varied in history, said Cook. Alan Greenspan, for example, “made sure that he stayed in the good graces of [Bill Clinton],” she noted. But Paul Volcker, who served as Fed chair under Presidents Jimmy Carter and Ronald Reagan, took a different approach, she said. “He just hiked interest rates out of this world, he contained the inflation rate and it actually worked.” Ben Bernanke had “a good working relationship in managing the financial crisis,” but he crafted his approaches in consultation with representatives of the Bush and Obama administrations, she added.

A big factor in how Fed chairs relate to the President is a concern about how history will record their work, according to Zaring. “One of the things that Fed chairs think about when they think about their legacy is how independent were they from the President, and there are a lot of things that go into that independence calculation,” he said. For instance, Arthur Burns, the Fed chair from 1970 to 1978, “was thought to be too close [to Richard Nixon], and it’s hurt him as far as the way he is viewed by people today,” he recalled. “So Fed chairs have a legacy-oriented reason to keep their distance, and that arm’s length relationship characterizes — maybe with the exception of Greenspan — most of the recent chairs.”

“It would be a shame and very difficult if there were a loss of memory of how the financial crisis came about and why this regulation … was put in place.”–Lisa Cook

Both Cook and Zaring were concerned about the possibility that Yellen could step down before her term expires. President Trump has said he would like to replace Yellen when he gets a chance, but Yellen has made it clear that she will complete her term. But “this environment is poisonous,” said Cook, referring to the rumor mills suggesting that she may quit. “I lived in Russia, so I saw how that can happen, but it happens in this country, too.” She added that it would make it easier for Trump to replace Yellen if there were a rumor that she was ready to step down. In any event, Yellen could stay on as a member of the FOMC until January 2024, Zaring noted.

Cook noted that Yellen has risen through the ranks of the Federal Reserve and is “very popular” internally in her organization. Yellen has also ensured open communication channels, she said. “She is a person who allows information to flow to the top.”

Stirrings of a New Order

While the Fed and the regulatory regime face headwinds, regional Federal Reserve banks could act as an effective check, said Zaring. “One of the reasons they are so important to the way the organization works is because we were always uncomfortable in America with an almighty central bank so they tried to create these regional institutions that could check the power of one all-powerful Fed chair,” he said. Regional banks also serve an important function in interacting with the businesses in their communities, he added. “In addition to being this trust of the central government, it is also a means by which there can be a flow of information,” said Cook.

Zaring noted that even if Congress and the President want to roll back regulations, they cannot have it their way all the way. “The Fed is still going to be there in bank holding companies, supervising their day-to-day activities,” he said. “That informal oversight can really retain a lot of regulatory supervision.”

Replacing the old guard in monetary policy and bank regulation with new faces could have damaging effects, according to Cook. “It would be a shame and very difficult if there were a loss of memory of how the financial crisis came about and why this regulation … was put in place,” she said. While some aspects of laws and regulations could be tweaked, “there has to be some institutional memory,” she added. “There has to be a memory about what was happening before our system was going gangbusters and the economy was growing and we were adding jobs like we are now. There has to be sensitivity to that, and to protecting consumers.”

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