FEDERAL RESERVE BANK

OF RICHMOND
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PERSPECTIVES ON MONETARY POLICY INDEPENDENCE

A Federal Reserve that is insulated from short-term political pressures but accountable to public concerns
is more likely to pursue policies that align with its congressional mandate to promote stable prices, full
employment, and moderate long-term interest rates.

KEY POINTS
n A
 central bank with independence in the conduct of monetary policy can more credibly commit
to promoting price stability and maximum employment in the long run.
n E lected officials face political incentives to favor accommodative monetary policies that
promote short-run gains in output and employment and reduce the real value of government
debt. But these policies pose long-run inflationary risks.
n The Fed solidified its monetary policy independence in the late 1970s and early 1980s by com-
mitting to monetary tightening to reduce high and persistent inflation, despite the widespread
unpopularity of such actions at the time.
n R
 ecent actions by the Fed have blurred the line between monetary policy and credit policy,
putting the Fed’s monetary policy independence at risk. To preserve its monetary policy inde-
pendence, the Fed should be cautious about taking actions that allocate credit to specific firms
or markets.
n The Federal Reserve System is decentralized by design but accountable to Congress. This mix
of independence and accountability has been beneficial to both the public and the economy.

Last updated on October 26, 2016

DISCUSSION

T he Federal Reserve has a number of respon-

sibilities, but its most visible role is the for-
mulation of monetary policy. While the Federal
of Governors, Current FAQs).
Elected governments in a democratic society
potentially face incentives to pursue accommoda-
Reserve’s Board of Governors is appointed by tive monetary policies that promote output and
the president and approved by the Senate, and employment for political gain in the short run,
the chairman of the Board reports to Congress even when those policies would eventually lead
biannually, the Fed conducts monetary policy to inflation. Central banks that are independent in
without further legislative or executive branch the conduct of monetary policy can better main-
involvement. A consensus has evolved among tain credibility for consistently pursuing price-lev-
economists that a Fed with independence in the el stability than those that do not enjoy indepen-
conduct of monetary decisions is more likely to dence. The case for central bank independence is
pursue policies that align with its congressional necessarily limited in other non-monetary policy
mandate, last revised in 1977, to promote the operations, however, as a central bank serves a
goals of moderate long-term interest rates, maxi- public purpose and must be accountable to the
mum employment, and stable prices (See Board government.

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Economic Arguments for Monetary Policy Clemson University economist David Gordon (Barro
Independence and Gordon 1983), have studied the interaction be-
The arguments in favor of monetary policy indepen- tween lack of policy commitment and inflation. In their
dence derive from a central bank’s monopoly over analyses, monetary policy can affect the real economy
money creation. This monopoly carries with it certain only through expansions that come as a surprise to
powers that elected governments may be tempted to the public. These expansions are tempting to pursue if
misuse for short-term benefits at the cost of rising in- there are inefficiencies in the economy that make real
flation over time. Resisting such temptations requires a activity undesirably low. For example, labor or product
degree of commitment on the part of the central bank, markets may not be perfectly competitive, and some
and without independence, that commitment might wages and prices may be inflexible.
be difficult to maintain. If monetary policy is controlled by a government
Two broad incentives might lead a government- that cannot commit to its future policy behavior, then
controlled central bank to abuse its money-creation such surprise expansions would result in a high infla-
powers. First, money creation that leads to unexpected tion rate but no benefit in terms of real activity — over
inflation reduces the real value of nominal liabilities, time the public would no longer be surprised by the
such as interest-bearing debt. In turn, this relieves the monetary expansions. But if monetary policy is con-
government of the need to increase taxes or reduce ducted under commitment, the economy can benefit
spending to balance its budget. Second, a surprise from lower inflation with the same level of real activity
monetary expansion can increase output and em- (for example, see Wolman 2001). Insulating monetary
ployment in the short run, permitting governments policy decisions from short-term political pressures
to engineer expansions in an effort to increase their can facilitate such commitment.
popularity.
The temptation for governments to use money Evolution of Monetary Policy Independence
creation to inflate away the real value of nominal From the passage of the Federal Reserve Act of 1913
liabilities has been studied by Columbia University until 1935, the Federal Reserve Board of Governors
economist Guillermo Calvo (Calvo 1978) and Univer- was relatively closely tied to the federal government.
sity of Chicago economists Robert Lucas and Nancy The Board was composed of five members appointed
Stokey (Lucas and Stokey 1983), among others. For to staggered 10-year terms by the president and two
instance, take a case of extreme lack of policy commit- ex-officio members, the secretary of the Treasury and
ment in which decisions are made with no regard for comptroller of the currency. The Fed was subordinate
past promises. If there is nominal debt outstanding, to the U.S. Treasury’s priorities. For example, it was
then ignoring the costs of inflation, the government called upon to help fund World War I by lending mon-
might choose to produce a monetary expansion large ey to banks to buy Liberty bonds.
enough to eliminate or greatly reduce the real debt. But in the wake of the stock market crash and the
Over time, though, the public would come to expect Great Depression, Congress passed the Banking Act
such behavior and this would result in ever-higher of 1935, which made the Board the center of power in
inflation and nominal interest rates. the Federal Reserve System. Its seven governors, plus
This vicious cycle can be forestalled through a com- five of the 12 Reserve Bank presidents serving on a
mitment to future low-inflation policies. A central bank rotating basis, became the Federal Open Market Com-
with independence in the conduct of monetary policy mittee (FOMC) and gained the authority to buy and
can provide such commitment because the formation sell U.S. government securities on the open market.
of monetary policy occurs outside the day-to-day The Act also gave the Board the power to set minimum
demands of government finance and the sphere of legal reserve requirements, within a certain range, for
political influence. member commercial banks and to fix the discount
University of California, Santa Barbara economist rate that the Reserve Banks charged member banks
Finn Kydland and Arizona State University economist for loans. In addition, the Act removed the secretary
Edward C. Prescott (Kydland and Prescott 1977), as of the Treasury and his deputy, the comptroller of the
well as Harvard University economist Robert Barro and currency, from the Board of Governors.

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 Challenges to the Fed’s ability to independently set a central bank’s balance sheet and holds the stock of
monetary policy arose during World War II when the monetary liabilities fixed (Goodfriend 2001). The Fed
Fed committed to a low-interest rate peg on govern- has been called upon to provide liquidity to specific
ment bonds at the Treasury’s request in 1942. This firms or sectors several times in its history. During the
allowed the federal government to finance the war Great Depression, the Fed was given the authority to
with cheaper debt. But support of government debt make loans directly to businesses (Sablik 2013). Part of
required the Fed to relinquish control of its portfolio that authority was repealed in 1958, but the Fed faced
size and the money supply. After the war, the conflict renewed pressure from Congress in the 1960s to ex-
escalated between the Fed and the Treasury over tend credit to specific sectors of the economy. In 1966,
which agency should control monetary policy. the Federal Reserve Act was modified to allow the
The dispute came to a head when the Treasury Fed to purchase agency debt to support the housing
directed the central bank to maintain the interest rate market, and Congress exerted strong pressure on the
peg after the Korean War started in 1950. President Fed to exercise that power (Haltom and Sharp 2014).
Truman wanted to protect the value of war bonds, The Fed used this authority again in 2008 to conduct
while the Fed wanted to contain inflationary pres- “quantitative easing,” a policy of expanding its balance
sures caused, in part, by the war. Many members of sheet through the purchase of agency debt in order to
the FOMC understood that the low peg on interest stimulate the economy.
rates would produce excessive monetary expansion Credit policy is a form of fiscal policy and has distri-
and inflation. These events led to the Treasury-Federal butional or public finance consequences that can put
Reserve Accord of 1951. Details from the era pro- monetary policy independence at risk (Goodfriend
vide insight into the Fed’s effort to resist inflationary 2012, Lacker 2011). Moreover, the ability to conduct
pressures by raising short-term interest rates while credit policy is inessential to the Fed’s core monetary
the Treasury wanted lower interest rates, a recurring policy mission and can potentially contribute to finan-
tension in later decades (Hetzel and Leach 2001). cial instability (Haltom and Lacker 2014). To preserve
The Accord eliminated the Fed’s obligation to mon- its monetary policy independence, and thus protect its
etize the Treasury’s debt at a fixed rate, allowing the ability to maintain price stability, Richmond Fed econ-
Fed to conduct monetary policy by varying the size omists have advocated that the Fed limit its purchases
of its balance sheet. This is a cornerstone of the Fed’s to Treasury debt. This would leave fiscal decisions to
independent monetary policy. Congress, which is subject to public review and the
A significant test of the Fed’s ability to maintain checks and balances of the political system (Broaddus
independence occurred in the late 1970s and 1980s, and Goodfriend 2001). Richmond Fed President Jeffrey
when Federal Reserve Chairman Paul Volcker took Lacker cited these arguments in his dissents against
widely unpopular measures to reduce monetary the Fed’s agency debt holdings and swap agreements
accommodation that had led to high and persistent to support foreign currency lending during and after
inflation. These measures contributed, in part, to the the 2007–09 recession (Lacker 2011, Lacker 2012a,
significant recession of 1981– 82, but they brought Lacker 2012b, Lacker 2012c, Lacker 2014, Lacker and
about lower rates of inflation and, not long after, the Weinberg 2014).
economy experienced a sustained period of growth. Additionally, the extension of credit to specific firms
The Fed’s actions during this period helped to soli- under lending facilities operated by both the Fed and
dify its independence and its credibility to pursue the Treasury during the financial crisis blurred the
price stability. distinction between the responsibilities of those two
The Fed’s monetary policy independence also can institutions. Those measures arguably have bolstered
be threatened when the line between monetary policy the case for a formal “credit accord” that would spell
and credit policy becomes blurred. The latter — which out which actions should be undertaken by the Fed
includes liquidity assistance to institutions, sterilized and which should be performed by the Treasury
foreign exchange operations, and transfers of Federal (Lacker 2009).
Reserve assets to the Treasury for the purpose of Another source of concern is the United States’ cur-
deficit reduction — changes the asset composition of rent fiscal situation. Although investors remain willing

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to lend to the United States at very low rates, that the Fed to disclose the amounts, terms, and condi-
might change if investors fear that the United States tions of its emergency and discount window lending
will not be able to generate sufficient surpluses in the and open market transactions. The Act also specified
future to cover interest payments on the outstanding that Reserve Bank directors representing the banking
debt. If that were to occur, it could prompt a fiscal industry not participate in the hiring of Reserve Bank
crisis that would overwhelm the central bank’s com- presidents. The Act maintained the exclusion from
mitment to keep inflation low and stable (Haltom and GAO audit of monetary policy deliberations, decisions,
Weinberg 2012). and actions — the aspects of monetary policy imple-
Monetary policy independence also may be jeop- mentation on which the chairman of the Board of
ardized by lawmakers’ temptation to draw funds from Governors reports directly to Congress.
the Fed to plug particular fiscal holes. For example, The governance of the Federal Reserve has changed
a five-year transportation bill signed into law in late significantly over its 100-year history. The Fed’s con-
2015 raised those concerns because some of its fund- duct of monetary policy is now largely independent
ing came from the Fed’s capital surplus account and of political forces that otherwise might lead to less
from a reduction in dividend payments to member desirable policy actions and outcomes. However, sev-
banks (Fessenden 2015). Such actions may have con- eral important checks and balances ensure that the Fed
sequences for the Fed’s relationship with banks and for does not become insulated from public concerns. On
Fed governance that adversely affect monetary policy balance, this system of governance, one of indepen-
independence (Lacker 2015). dence but also accountability, has been beneficial to
the public and the American economy.
The Central Bank’s Structure and Public
Accountability
The Federal Reserve System is decentralized by design. REFERENCES
It combines the benefits of its 12 regional Reserve Richmond Fed References
Banks with a government agency, the seven-member
Board of Governors in Washington, D.C. The inde- Broaddus, J. Alfred Jr., and Marvin Goodfriend. “What Assets
Should the Federal Reserve Buy?” Federal Reserve Bank of
pendent Reserve Banks serve as conduits, providing
Richmond Economic Quarterly, Winter 2001, vol. 87, no. 1,
economic data from regions across the country and pp. 7–22.
research from a variety of analytical perspectives. The
Fessenden, Helen. “A Bridge Too Far?” Federal Reserve Bank
Reserve Banks also collect timely grassroots infor-
of Richmond Econ Focus, Third Quarter 2015, vol. 19, no. 3,
mation from personal contacts that describe local pp. 4–7.
economic conditions. This information is critical to
Goodfriend, Marvin. “Why We Need an ‘Accord’ for Federal
the formation of monetary policy, especially in times
Reserve Credit Policy: A Note.” Federal Reserve Bank of
of financial stress. Richmond Economic Quarterly, Winter 2001, vol. 87, no. 1,
The Reserve Banks are governed by nine-member pp. 23–32.
boards that represent the public; they come from com-
Haltom, Renee, and Jeffrey M. Lacker. “Should the Fed Have
munities, businesses, and shareholder banks located a Financial Stability Mandate?” Federal Reserve Bank of
in each bank’s district. This structure helps support Richmond 2013 Annual Report, May 2014.
monetary policy independence by providing a diversi-
Haltom, Renee, and Robert Sharp. “The First Time the Fed
ty of voices within the System (Lacker 2016). Bought GSE Debt.” Federal Reserve Bank of Richmond
As noted, however, the Fed’s independence is Economic Brief No. 14- 04, April 2014.
limited to the conduct of monetary policy. In addition
Haltom, Renee, and John A. Weinberg. “Unsustainable Fiscal
to its regular reports to Congress, the Fed’s non-mone- Policy: Implications for Monetary Policy.” Federal Reserve
tary policy operations are audited by the Government Bank of Richmond Economic Brief No. 12-07, July 2012.
Accountability Office and a public accounting firm.
Hetzel, Robert L., and Ralph F. Leach. “After the Accord:
The Dodd-Frank Act also established several reviews Reminiscences on the Modern Fed.” Federal Reserve Bank
of the Fed’s lending programs — including an audit of Richmond Economic Quarterly, Winter 2001, vol. 87,
of lending during the financial crisis — and required no. 1, pp. 57–64.

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Lacker, Jeffrey M. “Government Lending and Monetary Lacker, Jeffrey M., and John A. Weinberg. “The Fed’s Mort-
Policy.” Address to the National Association for Business gage Favoritism.” Wall Street Journal, October 7, 2014.
Economics 2009 Washington Economic Policy Conference,
Lucas, Robert E. Jr., and Nancy L. Stokey. “Optimal Fiscal and
Alexandria, Va., March 2, 2009.
Monetary Policy in an Economy Without Capital.” Journal of
Lacker, Jeffrey M. “Understanding the Interventionist Im- Monetary Economics, 1983, vol. 12, no. 1, pp. 55–93.
pulse of the Modern Central Bank.” Speech at the CATO
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D.C., November 16, 2011.
Lacker, Jeffrey M. “Jeffrey M. Lacker, President, Federal Re- Research Publications
serve Bank of Richmond Statement on Dissenting Vote Federal Reserve Bank of Richmond
at FOMC Meeting November 28, 2011.” 701 East Byrd Street, 22nd Floor
Lacker, Jeffrey M. “Richmond Fed President Lacker Com- Richmond, VA 23219
ments on FOMC Dissent.” September 15, 2012; October 26, (804) 322-0565
2012; and December 14, 2012.
Lacker, Jeffrey M. “Richmond Fed President Jeffrey M. Lacker
Comments on Policy Normalization Principles and Plans.”
September 19, 2014.
Lacker, Jeffrey M. “The Fed-Bank Relationship Under Scruti-
ny.” Federal Reserve Bank of Richmond Econ Focus, Fourth
Quarter 2015, vol. 19, no. 4, pp. 1.
Lacker, Jeffrey M. “Does Federal Reserve Governance Need
Reform?” Speech at Marshall University, Huntington, W.Va.,
October 5, 2016.
Sablik, Tim. “Fed Credit Policy during the Great Depression.”
Federal Reserve Bank of Richmond Economic Brief No. 13-03,
March 2013.
Wolman, Alexander L. “A Primer on Optimal Monetary
Policy With Staggered Price-Setting.” Federal Reserve Bank
of Richmond Economic Quarterly, Fall 2001, vol. 87, no. 4,
pp. 27–52.

Other References
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Monetary Policy in a Natural Rate Model.” Journal of Political
Economy, August 1983, vol. 91, no. 4, pp. 589–610.
Board of Governors of the Federal Reserve System. “Why
Is It Important to Separate Federal Reserve Monetary
Policy Decisions from Political Influence.” Current FAQs.
Calvo, Guillermo A. “On the Time Consistency of Optimal
Policy in a Monetary Economy.” Econometrica, November
1978, vol. 46, no. 6, pp. 1411–1428.
Goodfriend, Marvin. “The Elusive Promise of Independent
Central Banking.” Keynote Lecture at the 2012 BOJ-IMES
Conference, Tokyo, Japan, May 30, 2012.
Kydland, Finn E., and Edward C. Prescott. “Rules Rather Than
Discretion: The Inconsistency of Optimal Plans.” Journal of
Political Economy, June 1977, vol. 85, no. 3, pp. 473–491.