Federal Reserve Transparency and H.R. 1207

Testimony by Scott G. Alvarez, General Counsel
Federal Reserve Transparency
Before the Committee on Financial Services, U.S. House of Representatives, Washington, D.C.
September 25, 2009

H.R. 1207 and Monetary Policy Independence

The Congress purposefully–and for good reason–chose to exclude from GAO review only two highly sensitive areas: one is monetary policy deliberations, decisions, and actions, including open market and discount window operations; and the other is Federal Reserve transactions for or with foreign central banks, foreign governments, and public international financing organizations. The limited exceptions for monetary policy and discount window operations were adopted to ensure that the Federal Reserve could “independently conduct the Nation’s monetary policy.”

Considerable experience shows that monetary policy independence–within a framework of legislatively established objectives and public accountability–tends to yield a monetary policy that best promotes price stability and economic growth. Monetary policy independence prevents governments from succumbing to the temptation to use the central bank to fund budget deficits. It also enables policymakers to look beyond the short term as they weigh the effects of their monetary policy actions on price stability and employment. And it reinforces public confidence that monetary policy will be guided solely by the objectives laid out in the Federal Reserve Act. Thus, the Congress has sought to maintain an independent monetary policy not because it benefits the Federal Reserve, but because of the important public benefits it provides.

Through its investigations and audits, the GAO typically makes its own judgments about policy actions and the manner in which they are implemented and makes recommendations to the audited agency and to the Congress for policy changes or future policy actions. Accordingly, financial markets likely would see the grant of audit authority to the GAO with respect to monetary policy as undermining the Federal Reserve’s independence in this crucial area, particularly because GAO audits or the threat of a GAO audit could be used both to second-guess the Federal Reserve’s monetary policy judgments and to try to influence subsequent monetary policy decisions.

Permitting GAO audits of monetary policy also would likely cast a chill on monetary policy deliberations if policymakers believed that GAO audits would result in early publication and analyses of their policy discussions. Unfettered and wide-ranging internal debates are essential to identifying the best possible policy options for achieving maximum employment and stable prices in light of data that may be conflicting or, at best, ambiguous as to the optimum policy path.

Moreover, publication of the results of GAO audits related to monetary policy actions and deliberations would complicate and interfere with the FOMC’s communications to the markets and the public about current economic conditions and the appropriate stance of monetary policy. Households, businesses, and financial market participants would understandably be uncertain about the implications of the GAO’s findings for future decisions of the FOMC, thereby increasing market volatility and weakening the ability of monetary policy actions to achieve their desired effects.

The exception from GAO audit for monetary policy matters rightfully extends to the Federal Reserve’s use of market credit and liquidity programs to support the functioning of financial markets, stimulate the economy, and unfreeze credit markets. During the crisis, as use of the federal funds rate and discount rate to achieve policy objectives became constrained by the zero bound, the Federal Reserve established several broadly available market credit facilities.8 These broad-based facilities are fundamentally different from the institution-specific loans that the Federal Reserve has made and that are already subject to GAO audit. These broader market facilities are designed to unfreeze credit markets and lower interest rate spreads and are a natural extension of the traditional central bank responsibility to serve as a backup source of liquidity during periods of financial strain.9 In this way, these facilities represent an essential part of the Federal Reserve’s efforts to promote financial stability and its monetary policy objectives.

Permitting GAO audits of discount window lending and the broad liquidity facilities that the Federal Reserve uses to affect credit conditions generally could reduce the effectiveness of these facilities in promoting financial stability, maximum employment, and price stability. Experience, including during the current financial crisis, shows that banks’ unwillingness to use the discount window can result in high and volatile short-term interest rates and greatly limit the effectiveness of the discount window as a tool to enhance financial stability. Indeed, one of the important difficulties that hampered the effectiveness of the Federal Reserve’s early response to the crisis was the unwillingness of many banks to draw discount window credit because of concerns about stigma; institutions were concerned that, if their discount window borrowing from the Federal Reserve became known, they would be subject to adverse reactions from the market or other sources. Authorizing the GAO to audit the discount window and other broad-based lending programs could significantly increase potential borrowers’ fears of stigma and adverse reactions.

H.R. 1207 would completely remove the exceptions from GAO audit in current law for monetary policy and discount window deliberations and operations, thereby allowing frequent and ongoing audits in these areas. Financial market participants likely would see passage of H.R. 1207 as a substantial erosion of the Federal Reserve’s monetary policy independence. Accordingly, enactment of the bill would tend to undermine public and investor confidence in monetary policy by raising concerns that monetary policy judgments in pursuit of our legislated objectives would become subject to political considerations.

These concerns likely would increase inflation fears and market interest rates and, ultimately, damage economic stability and job creation. Indeed, the bond rating agencies view operational independence of a country’s central bank as an important factor in determining sovereign credit ratings.10 Actions that weaken monetary policy independence thus could raise the Treasury’s cost of borrowing. Higher long-term interest rates would further increase the burden of the national debt on current and future generations.

Adoption of H.R. 1207 also could disrupt the nation’s relationships with foreign central banks and governments, relationships which are helpful in supporting the Federal Reserve’s efforts to fulfill its statutory missions, and erect barriers to official cooperation among central banks and governments. Foreign central banks and governments likely would be less willing to engage in financial transactions with the Federal Reserve if these transactions were subject to policy review by the GAO, as H.R. 1207 would allow. These transactions, such as the deposit of international reserves and bilateral currency swap arrangements, help support the role of the dollar as a worldwide reserve currency and alleviate stresses in U.S. financial markets. For example, the temporary liquidity swaps entered into by the Federal Reserve with other central banks are designed to improve liquidity conditions in both domestic and international financial markets, guard against the spillover of volatility in foreign trading to U.S. money markets, and thereby reduce funding pressures in U.S. financial markets.

The modifications proposed by H.R. 1207 are not needed to allow the GAO to audit the Federal Reserve’s supervisory and regulatory programs for banking organizations, its consumer protection functions, or the many other aspects of the Federal Reserve’s responsibilities that are not related to monetary policy or transactions with foreign authorities. As I noted earlier, the GAO already has and exercises authority to conduct audits in these areas, and the Federal Reserve cooperates fully with the GAO on these reviews.

The Federal Reserve recognizes that there may be ways to further enhance the review of the operational integrity of our market credit facilities without endangering our ability to independently determine and implement monetary policy. We have worked and will continue to work with this Committee and the Congress to ensure that our credit facilities are operated in a way that promotes the highest standards of accountability, stewardship, and policy effectiveness.

Obvious to all except Ron Paul and the morons at zerohedge.