Congress Reconsiders Fed’s Independence – It’s Time To Be Concerned

Thursday, November 12, 2009

Capitol-FedPoliticians regularly deliver “grin and bear it” moments. Mostly, we write them off as political life’s peculiarities. Occasionally, though, proposals come along that run counter to long-held beliefs and accepted principles. They can be brilliant, or they can be dangerous. I believe one of the latter variety is upon us – an effort to reduce the Federal Reserve’s independence.

The Federal Reserve’s independence is important to the US financial system’s effectiveness, and it creates confidence and trust here and abroad.

A central bank must be able to take actions that it believes are best for the financial system, even if it means saying “No!” to politicians. Elected officials have a bias that can influence their thinking: Popularity produces votes. Central bankers, to succeed at their mission, must occasionally take unpopular actions. In fact, some of their most valuable acts are contrary to currently popular beliefs and desires.

The difference in approach is shown by a congressman’s recent lament that the Fed was unpopular with both Democrats and Republicans. Seen through the politician’s eyes, that was a problem. However, from a financial expert’s point of view, it means the Fed is successfully walking the line again, giving in to neither side’s opposing demands – easy money to support economic and jobs growth versus tight money to prevent excess speculation and inflation.

Does this mean that central banks always act wisely with accurate foresight? No. But their record far exceeds that of politicians. And, most importantly, the financial world accepts a central bank’s missteps, knowing the mistakes were free from ulterior motives.

In spite of these well-know principles, congress is pushing to get some control over the Federal Reserve, reshaping it in their interests.

From the Republican side, Representative Ron Paul (who recently wrote a book, End the Fed) has introduced a bill to “audit” the Federal Reserve. He has widespread support in both the Senate and the House.

From the Democrat side, Senator Chris Dodd, chairman of the Senate Banking Committee, just introduced a bill that proposes fundamental changes:

The financial-regulation overhaul proposed yesterday by Senator Christopher Dodd would strip the Fed of its role as a bank supervisor and give Congress a greater voice in naming the officials who set interest rates. The measure opens the door to interference from politicians who might disagree with any move by the Fed to raise rates from record lows, former central bank officials said. (“Fed Faces Biggest Blow to Authority in Dodd Proposal”, Bloomberg News, November 11)

Why now, after the Fed has been a leader in helping the US financial system regain its footing from last year’s turmoil? And after the Fed worked with the US Treasury to ensure the large, financial actions being taken by congress would have the desired effects?

The cynical-sounding answer is probably accurate: savvy politicians redirecting the spotlight as voters’ search for someone to blame. Voters have been looking at Congress’ inaction regarding out-of-date, ineffective regulatory controls. The “do-nothing” label has produced turnover before, so politicians fear it.

Senator Dodd’s statement, when he presented his bill, is a perfect example of this shift-the-blame strategy.

Over the last number of years when [the Fed] took on consumer-protection responsibility and regulation of bank holding companies, it was an abysmal failure.

So, he claims the Federal Reserve is to blame, not his Senate Banking Committee, which is responsible for the drafting and oversight of the banking regulations, and on which Senator Dodd has sat for 26 years. (No, this is not a rant – just the facts that belie his anti-Fed comments.)

Such actions may be politically clever, but this one is seriously shortsighted with potentially adverse consequences.

From an investment standpoint, these proposals add additional risk to holding longer-term bonds. The risk comes from the uncertainty about congress’ willingness to fight future inflation. Here’s hoping cooler and wiser heads prevail, and we see these proposals fade away.

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John Tobey on Seeking Alpha

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November 2009