Bankers are well aware of the unprecedented actions taken by the Federal Reserve in the fall of 2008 to stem the downward spiral of the financial crisis. At various points in time, the Fed had more than $1.5 trillion outstanding in loans to financial institutions and, more recently, has purchased $1.25 trillion of mortgage-backed securities to stabilize the economy.
The magnitude of the Fed’s response to the financial crisis has caused some to question why the Fed has the freedom to engage in such actions without the explicit consent of Congress. This freedom to stabilize the financial system without political direction is commonly referred to as “central bank independence.”
Legislation recently passed by the House of Representatives could affect central bank independence by permitting frequent and ongoing reviews of monetary policy and financial stability decisions, deliberations and actions by the Government Accountability Office (GAO). Currently, monetary policy actions are not subject to GAO review.
The implications of such reviews are significant and concerning. GAO reviews of discount window loans, for example, could serve to dampen the willingness of banks to borrow from the discount window during periods of financial instability. Take, for example, the first two days following the tragic events of Sept. 11, 2001. If banks had been reluctant to use the discount window for fear of GAO disclosure, would our financial system have rebounded so quickly?
The implications for monetary policy effectiveness must be carefully weighed. The Federal Reserve’s ability to act in the long-run best interests of the economy depends importantly on its credibility and independence from short-term political pressures, including the temptation of governments to use the central bank to fund budget deficits or alter the way monetary policy is conducted. Numerous studies have shown that countries whose central banks are protected from short-term political influence have better economic performance, including lower inflation and interest rates.
Without question, the Federal Reserve should be accountable to the electorate for its actions. However, audits by the GAO are not the best way. Indeed, retaining the independence of the central bank may well be the best method for preventing government from misusing monetary policy for short-term political purposes.
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