Fed's response may make withdrawal tricky
Thursday, November 12, 2009
The Federal Reserve has over the decades viewed its independence from political influence as crucial for its ability to guide the U.S. economy.
But the central bank's activist response to the financial crisis has exposed the Fed to immense political fallout. That will make it more difficult for the Fed to carry out its responsibilities of guiding the national economy out of a recession and withdrawing its emergency support for the economy at just the right time, say former Fed officials and others who closely follow the central bank.
Chairman Ben S. Bernanke, whose confirmation for a second term is pending in the Senate, is attempting a quiet campaign to maintain the Fed's standing on Capitol Hill, defending the central bank's handling of the financial crisis in private meetings with lawmakers and occasional public appearances. But so far, that approach has failed to shift the reality that the central bank is under fire as in no time since the Great Depression.
This week, Senate Banking Committee Chairman Christopher J. Dodd (D-Conn.) called for stripping the Fed of its long-standing authority to regulate banks along with changing how regional Fed banks are governed. A bill proposed by Rep. Ron Paul (R-Tex.), author of the book "End the Fed," would increase oversight of the Fed's management of the money supply. The measure has been co-sponsored by a majority of the House.
And the aggressive steps the Fed has taken to rescue the economy in the last two years, such as bailing out American International Group and supporting lending for credit cards, mortgages and other kinds of lending, has left the central bank open to calls by elected officials that it do the same for their favored industries.
Dodd says his proposals will make the Fed better able to reach decisions about interest rates and other aspects of monetary policy without political influence, by removing the entanglements of bank supervision. "You start loading up the Fed with additional responsibilities and that independence can be threatened, in my view, and I think that would be a mistake," he said Tuesday.
The Obama administration, by contrast, views the Fed as the agency best positioned to oversee major banks. These competing visions could lead to conflict as legislation to overhaul financial regulation moves ahead.
Independence at issue
The threats hanging over the central bank could compromise its independence, warn Fed watchers. Several crucial decisions are approaching, including how to continue phasing out its emergency efforts to support the economy. The Fed has already said it will wind down the purchases of mortgage securities in March after buying about $1.25 trillion worth. In the more distant future, to avoid the risk of inflation, the central bank will need to raise its target interest rate above the current level near zero.
Rate increases are always unpopular, particularly when the unemployment rate is still high. But the political environment could make the decision even tougher.
"The current unpopularity of the Fed will make it more difficult for them to raise interest rates when the economy recovers," said Karen Dynan, a former senior Fed economist who now heads the economic studies program at the Brookings Institution. "With the Fed under such close scrutiny, any move to raise interest rates will be challenged even more strongly than in the past."
In previous decades, the Fed has successfully rebuffed political pressure on its interest rate decisions. Chairman Paul Volcker was publicly pilloried in the early 1980s when his interest rate hikes, meant to end the inflation of the 1970s, drove the unemployment rate to a post-war high. In the early 1990s, the administration of George H.W. Bush openly attacked the Fed for keeping interest rates high, and Chairman Alan Greenspan endured bitter criticism from Congress.
Current and former Fed insiders find it unthinkable that politics would ever play a direct role in Fed policymaking. It is part of the culture of the institution to keep political considerations out of discussions when setting monetary policy. But with the Fed's powers under threat, insiders say there could be more subtle pressure to move slowly in ending programs and raising rates.