With Donald Trump set to take office in January and the Republican majority in Congress, his statements about reining in the Federal Reserve (Fed) are now turning into rumblings of reform bills in Congress.
Could an automated system carry out the same functions as those done by living, breathing and thinking central bank officials? In the early 1980s, when Ronald Reagan took over as President, there was speculation that a computer program could be used to determine interest rates rather than the Federal Reserve. As of late, there have been arguments that the Fed should adopt a rules-based approach using a mathematical formula to determine rates rather than a discretionary approach.
These ideas are part of a global wave of scepticism around the effectiveness of the unconventional policies employed by central banks of developed countries. The Fed has taken the lead in turning its back on these policies, it no longer has a quantitative easing programme, unlike counterparts in the UK, Europe and Japan. The Fed is virtually the only major developed central bank on the road to restoring rates to normal levels.
However, some Republicans believe the Fed is not restoring rates fast enough. There have been calls for the Fed to be more accountable to the government and to adopt a rules-based approach to monetary policy. Last year, a bill designed to achieve this – the Fed Oversight Reform and Modernization (FORM) Act – was passed in the House of Representatives. A key proponent of the bill was Senator Rand Paul – a Republican presidential candidate at the time. Earlier this year, the bill failed to clear the Senate, largely because of Democrat-led opposition. Even if passed, it would have been vetoed by President Obama.
Circumstances have now changed – a Republican president is set to take office next month and his party will have a majority in the House and the Senate. In the near-term, the scope for Republicans such as Mr. Trump and Senator Paul to sway the Fed is limited without legislation, as there are currently only two vacancies out of seven on the Fed’s board. Fed Chairperson Janet Yellen’s intention to remain in her role until 2018 may make the proponents of the Act even more determined to reform the Fed using legislation.
The FORM Act could curtain the Fed’s ability to function as an independent central bank, according to former chairman Ben Bernanke. A central bank subject to political control is viewed as undesirable by policymakers.
Earlier this year, the IMF’s Managing Director said “central banks have to be independent in conducting their monetary policies”. Moves to limit the Fed’s independence could also lead to similar moves in other countries where there are already concerns about the freedom central banks enjoy.
This could have dangerous implications, especially in emerging markets. If central banks in these countries are not independent, they could come under political pressure to lower rates before elections, to make it easy for the incumbent government to unleash spending to win votes. This would be particularly undesirable in countries that are not full-fledged democracies.
On the other hand, in developed countries, arguments that there should be curbs on central bank independence are largely inspired because of concerns that rates are too low. The UK’s Prime Minister as well as the Opposition Leader have criticised the Bank of England’s (BoE’s) low rates and QE programme. Ed Balls, one of the politicians who took part in making the bank independent in the 1990s, recently expressed arguments against the BoE’s independence. Similar arguments have also been expressed in the Eurozone over the extent of the European Central Bank’s (ECB’s) powers; German politicians have argued that low rates are harmful to savers.
Curbs on central banks’ independence may limit their abilities to calm markets when things go wrong, especially if their actions are also restricted by formulas tied to economic indicators. Since the crisis, markets have often been calmed by the fact that central banks will be around to “save the day”.
Formula-based approaches may limit the scope of a central bank to function as a monetary backstop. Imagine if the ECB’s powers had been restricted in 2012; markets may not have been reassured that President Mario Draghi actually could “do whatever it takes” to prevent the eurozone’s break up. More recently, markets recovered quickly since Brexit, partly because investors took comfort in the fact that the Fed would postpone rate hikes and hoped that the BoE and the ECB would boost stimulus programmes.
Moreover, any new system that overhauls central banks’ operations would take time to gain credibility and acceptance. Ms Yellen expressed concerns about the effectiveness of using formulas to determine rates.
Based on one such formula – the Taylor Rule – the Fed should have pushed rates below zero during the crisis and hiked rates well before 2015. The chart shows what the Fed’s benchmark rate – the federal funds rate – would look like if it was determined by this rule.
Source: Federal Reserve Bank of Atlanta
This shows that if the reforms were implemented, the Fed might have to hike rates faster than currently planned, to conform to the rule. The long-run projection of federal funds rate (made in September) is less than 3% – below what the Taylor Rule says it should currently be. A knee-jerk increase in rates to Taylor Rule-prescribed levels could destabilize markets.
Proponents of formula-based approaches argue that there are benefits. However, a crucial drawback is that such formulas – unlike central bankers – rely heavily on underlying economic indicators. Often, these may not be an accurate representation of the true picture. For instance, a low unemployment rate may result in a Taylor Rule-inspired formula prescribing a higher interest rate, but would this really be the best solution if unemployment is low because people are dropping out of the labour force?
Indicators, and hence formulas based on these, are not as effective as human beings in factoring in unknown, and often unseen, elements. If the BoE had used such a formula, it would have been difficult to compute exact growth and inflation figures to use as inputs into the model when Brexit occurred.
Curtailing the Fed’s independence and making rates subject to formulas is unlikely to ensure that Trump will succeed at “making America great again.” Measures to rein in the Fed could lead to similar moves elsewhere, which could have serious repercussions as the proposed new methods and formulas may neither be fully credible nor easily implemented.