Rewriting the Rules of the Fed: Testimony on the Full Employment Federal Reserve Act of 2015
December 1, 2015
Congressman Conyers and members of the Full Employment Caucus, thank you for the privilege of speaking to you today on the issue of the Federal Reserve accountability to the public—a topic of perennial importance that has become even more pressing in recent years. My name is Carola Binder and I am a professor of economics at Haverford College and a Visiting Fellow at the Roosevelt Institute. Today I will explain why I believe that reforms to Fed governance and communication are important steps toward aligning the Fed’s interests with those of American families.
The Federal Reserve System is best described as “independent within government,” not “independent of government.”[1] This critical distinction brings us here today. As you know, the Fed derives its authority from Congress and is subject to congressional oversight. Congress can alter the Fed’s responsibilities by statute, as it did with the Federal Reserve Reform Act of 1977, which directs the Fed to “promote the goals of maximum employment, stable prices, and moderate long-term interest rates.” But the Fed has considerable latitude and discretion in how it interprets, prioritizes, and pursues these goals. In practice, this means that the Fed heavily prioritizes price stability. In two weeks, Fed officials will likely vote to raise interest rates in order to slow inflation, which will also have the effect of restraining wage growth and job creation.
Many Americans, including members of the Full Employment Caucus and their constituents, would not choose to make this change at a time when labor market conditions have not yet fully recovered from the Great Recession. But these Americans do not vote for Federal Reserve officials. Instead, those officials are selected according to somewhat complicated and obscure protocols resulting from political conflicts and compromises made over the Fed’s 102-year history. Each regional Reserve Bank is governed by three Class A directors, elected by member banks to represent their interests, and a total of six Class B and C directors, who are intended to represent the public. The Federal Reserve Act states that Class B and C directors should be selected with “due but not exclusive consideration” to the interests of agriculture, commerce, industry, services, labor, and consumer representation. But just two out of 108 directors represent the interests of labor, and all but 15 come from the corporate or financial sector.[2] This imbalance has important implications, as recent research finds that the career backgrounds of Federal Open Market Committee members shape their preferences: Those with financial backgrounds are more focused on inflation stabilization and less focused on output stabilization.[3] [4]
The selection process for Fed officials means that central bank policy is quite different from other economic policies, like tax policy, which is conducted by elected representatives. Why, in a democratic society, do we delegate some policy tasks to elected officials and others to unelected technocrats? Alan Blinder, a Princeton University economist and former Vice Chairman of the Board of Governors, explains that some policies have “general” effects, affecting most citizens in similar ways, while others have “particular” effects, with different costs and benefits for different groups.[5] Tasks perceived as general are more often delegated to unelected technocrats, who are free from the political pressures that can lead to myopic choices. In contrast, policies that are particular require value judgments concerning who should win and lose. In a democratic society, the people making such value judgments should be held accountable to the public, so we often assign these tasks to elected officials. Conventionally, monetary policy is perceived as more general; former Federal Reserve Chair Ben Bernanke recently wrote that “[m]ost economists would agree that monetary policy…has limited long-term effects on ‘real’ outcomes like the distribution of income and wealth.”[6] [7]
Recent research and experience makes clear, however, that Fed policy does affect the distribution of resources.[8] The tradeoff between inflation and unemployment involves winners and losers at different parts of the income and wealth distributions. When labor market conditions are weak, lower-income families bear more of the burden of unemployment, and wages at the bottom and middle of the distribution stagnate. [9] Excessive emphasis on low and stable inflation leads monetary policymakers to tighten too early in the recovery phase of the business cycle, before the majority of workers can realize the benefits of full employment. As a result, unemployment is higher than its natural rate on average, and productivity growth does not translate into rising real wages and standards of living for most Americans.[10] Moreover, evidence of hysteresis means that periods of high unemployment caused by tight monetary policy can actually raise the long-run “natural” rate of unemployment.[11] [12]
The Fed also affects the income and wealth distributions through its choices about financial sector regulation and supervision. The individuals and firms that most benefit from lax regulation and supervision do not bear the full downside of the risks they take; their losses are shared by the larger economy. Financial crises keep the economy below full employment longer, thereby raising inequality. Financial crises also disrupt access to credit, an essential factor for human capital formation; creation of small-to-medium enterprises; and poverty reduction.[13] [14]
All of this means that monetary policymakers must be held accountable to the public at large. However, I do not believe that achieving accountability requires limiting the Fed’s independence by explicitly defining its goals in quantitative terms. Although I appreciate the spirit behind the proposal, there are two major reasons I am reluctant to amend the Federal Reserve Act to define maximum employment as “an economy with an unemployment rate of not more than 4 percent.” First, I am not confident that any specific unemployment rate is always appropriate or sustainable. Second, as the proposed text of the Full Employment Federal Reserve Act of 2015 states, “all branches of the Federal Government should use their full power to accomplish [full employment].” Other branches of government may become complacent if the unemployment rate is seen as the domain of the Fed.
How, then, can we increase the Fed’s accountability to ensure that Fed officials’ incentives align with the objectives of society at large, especially prioritizing full employment? One strategy is to reform Fed governance to minimize regulatory capture by the financial sector and ensure representation of broad economic interests. [15] In particular, Congress and the Fed must address the inherent conflict of interest created by the revolving door between positions in the Fed and private financial institutions. This would start with writing more explicit guidelines for “due consideration” to consumer and labor interests in the selection of regional bank board members, as well as for positions on the Federal Reserve Board of Governors. The Federal Reserve should also maintain an easily accessible, up-to-date public database of all directors, Regional Bank presidents, and members of the Board of Governors that includes information about their professional backgrounds.
Another key to improved accountability, in my opinion, is to vastly enhance the Fed’s public communication strategy. The Fed has made great strides in increasing its transparency in recent decades, but transparency, while necessary, is not sufficient for effective communication. As Ben Bernanke has noted, the Fed’s current communication strategy focuses on three target audiences: political authorities, financial markets, and the general public.[16] The Fed reluctantly began communicating with political authorities when the Full Employment and Balanced Growth Act of 1978 obligated the Fed Chair to participate in periodic congressional hearings. In more recent years, the Fed has voluntarily and effectively increased its communication with financial market participants. Communication with the general public is most lacking.
My research finds that the general public’s understanding and awareness of the Fed are quite low.[17] In part, this is because the Fed has not successfully learned to work with the plethora of media outlets to which households turn for their information. Media coverage of the economy tends to focus on the president.[18] Many households are uninformed about the Fed’s objectives and policies, and few report long-run inflation expectations that are near the Fed’s 2 percent target. Many have trouble even naming the Fed Chair.
The Gallup Poll asks people about their opinion of different government leaders. I hope I’m not the first to break it to you that not everyone loves Congress. But at least they have heard of you! In April 2014, less than 5 percent of households said that they had no opinion of Congress, and an even smaller number had no opinion about the president. But about 20 percent had no opinion of Bernanke, and a similar share now have no opinion of his successor, Janet Yellen. If the public remains uninformed about the Fed and believes that the president alone controls the strength of the economy, then they will hold only the president, and not the Fed, accountable for economic performance.
Does the Fed bear any responsibility for what the media covers and what households pay attention to? Absolutely. The Fed has to actively compete for households’ attention in the new media landscape. This requires ramping up its use of social and interactive media, using more accessible language, and explicitly tailoring communications to address the varying concerns of different demographic and socioeconomic groups. The Fed chair’s quarterly press conferences, for example, are tailored to the most financially savvy audiences. Why not, on alternating meeting dates, or at least annually, also hold public Q&A sessions similar to those held by the Swedish central bank’s governor, who takes less technical questions from members of the public?
Former Minneapolis Fed President Narayana Kocherlakota notes that “In order for the Fed to continue to be effective, it needs to communicate its policy decisions transparently to the public. Conversely, it also needs the public’s input into how those policies are affecting them.” The Fed created a Community Advisory Council (CAC) comprised of 15 members “with knowledge of fields such as affordable housing, community and economic development, small business, and asset and wealth building, with a particular focus on the concerns of low-and moderate-income consumers and communities.”[19] The first meeting occurred on November 20, 2015. The minutes or a recording of CAC meetings should be publicized along with Fed officials’ responses to concerns raised in those meetings.
In conclusion, contrary to conventional thinking, the rules of central banking are not neutral: Both monetary policy and financial supervision have profound effects on income and wealth inequality. These rules are not commandments etched in stone, but are instead the product of political contestation and compromise. It is time for Congress and the Fed to consider rewriting the rules of the Federal Reserve System to improve the transparency and accountability of the institution and better align the Fed’s interests and actions with those of working families. Thank you.
[1] Federal Reserve Bank of Richmond. “Federal Reserve System: Frequently Asked Questions.” Accessed 15 November 2015 at https://www.richmondfed.org/faqs/frs.
[2] Razza, Connie. (2015). “Wall Street, Main Street, and Martin Luther King Jr. Boulevard: Why African Americans Must Not Be Left Out of the Federal Reserve’s Full-Employment Mandate.”
[3] Stefan Eichler and Tom Lähner. 2014. “Forecast dispersion, dissenting votes, and monetary policy preferences of FOMC members: the role of individual career characteristics and political aspects.” Public Choice. 160:429-453.
[4] Bennani, Hamza, Etienne Farvaque, and Piotr Stanek. 2015. “FOMC members’ incentives to disagree: regional motives and background influences.” NBP Working Paper No. 221.
[5] Alan Blinder. (1997). “Is Government Too Political?” Foreign Affairs, November/December issue.
[6] Also see Alesina, Alberto and Guido Tabellini. 2007 “Bureaucrats or Politicians? Part I: A Single Policy Task.” The American Economic Review 97(1): 16-179.
[7] Bernanke, Ben. June 1, 2015. “Monetary policy and inequality.” Ben Bernanke’s Blog, Brookings. Accessed 21 June 2015 at http://www.brookings.edu/blogs/ben-bernanke/posts/2015/06/01-monetary-policy-and-inequality.
[8] Coibion, Olivier, Yuriy Gorodnichenko, Lorenz Kueng, and John Silvia. 2012. “Innocent Bystanders? Monetary Policy and Inequality in the U.S.” NBER Working Paper No. 18170.
[9] Heathcote, Jonathan, Fabrizio Perri, and Gianluca Violante, 2010. “Unequal We Stand: An Empirical Analysis of Economic Inequality in the U.S., 1967-2006.” Review of Economic Dynamics 13(1):15-51.
[10] Congressional Budget Office. February 2015. “Why CBO Projects That Actual Output Will Be Below Potential Output on Average.”
[11] Lawrence Ball. 2009. “Hysteresis in Unemployment: Old and New Evidence.”
[12] Lawrence Summers. 2014. “U.S. Economic Prospects: Secular Stagnation, Hysteresis, and the Zero Lower Bound” Business Economics 49(2): 65-73.
[13] Galor, O., Moav, O., 2004. “From physical to human capital accumulation: Inequality and the process of development.” Review of Economic Studies 71, 1001-1026.
[14] Demirgüç-Kunt, A., Beck, T., & Honohan, P. 2008. “Finance for All?: Policies and Pitfalls in Expanding Access.” Washington, D.C.: The World Bank.
[15] U.S. Government Accountability Office. October 2011. “Federal Reserve Bank Governance: Opportunities Exist to Broaden Director Recruitment Efforts and Increase Transparency.”
[16] Bernanke, Ben. 2003. “A Perspective on Inflation Targeting,” Annual Washington Policy Conference of the National Association of Business Economists, Washington, D.C.
[17] Carola Binder. 2015. “Fed Speak on Main Street.”
[18] Pew Research Center Journalism and Media Staff. October 5, 2009. “Covering the Great Recession.” Accessed 16 November 2015 at http://www.journalism.org/2009/10/05/who-drove-economic-news-and-who-didnt/.
[19] Federal Registrar. April 13, 2015. 80(70). Accessed October 29, 2015 at http://www.gpo.gov/fdsys/pkg/FR-2015-04-13/pdf/2015-08354.pdf.