How independent can central banks be? Specifically, how independent is the US Federal Reserve (‘the Fed’)?
Following the high inflation of the 1970s, many central banks were given greater responsibility for, and independence in, the conduct of monetary policy. That development helped to usher in a long era of declining and then stable inflation for most advanced economies (‘the great moderation’), which reinforced the appeal of central bank independence. But since the financial crisis of 2007-09, central banks have also become large buyers and holders of government debt. Those actions, however necessary they may have been, threaten central bank independence. Until that reality is acknowledged, the myth of central bank independence becomes increasingly misleading,
Like all central banks, the Fed is a fiscal and financial agent of the state. Despite the bizarre formal ownership structure of the twelve regional Reserve Banks, each of which is notionally owned by its member banks, the Federal Reserve System is beneficially owned by the federal government, which receives its net profits through remittances to the U.S. Treasury.
Since the 1951 Treasury-Fed Accord, the Fed has enjoyed varying degrees of operational independence (autonomy) in the pursuit of its monetary policy objectives, which are laid down in the Federal Reserve Act (maximum employment, stable prices, and moderate long-term interest rates). It has limited operational independence in the pursuit of its financial stability mandate, recently revised and augmented by the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act.
Operational independence, of course, means neither that budgetary policy choices do not influence Fed behavior nor that the policy choices of the Fed do not influence the actions of the Treasury. Operational independence can also be taken away, or the mandates can be changed.
Perceptions vs. Reality
The Fed’s statement on the interrelationship between budgetary policy and central bank policy actions contains assertions that must be qualified as well as assertions that are obviously incorrect. The following quotations are from its FAQs website, “How does the Federal Reserve’s buying and selling of securities relate to the borrowing decisions of the Federal government?”
We start with a flawed assertion of central bank independence: “All monetary policy decisions of the Federal Reserve – including buying and selling securities – are made independently of the borrowing decisions of the federal government and are intended solely to fulfill the mandate set out for the Federal Reserve by law – maximum employment, stable prices, and moderate long-term interest rates”.
First, what is meant by “independently”? Even if the Fed’s decisions on buying and selling Treasury securities are made by an operationally independent institution in which no-one (including the Treasury) tells the Fed what to do, these independent decisions are bound to be materially influenced by the borrowing decisions of the federal government and by the conditions in the markets for U.S. Treasuries.
The statement also ignores the financial stability responsibilities of the Fed. The Dodd-Frank Act recognized and formalized the macroprudential responsibilities of the Fed – without using the word ‘macroprudential’ although it mentions ‘systemic risk’ 39 times and ‘Federal Reserve System’ 141 times. The Fed intervened on a massive scale when the U.S. Treasury market experienced a sharp deterioration in liquidity conditions during the Covid crisis in March 2020. According to Fleming and Ruela (2020), between March 15 and March 31, 2020, the Fed purchased $775 billion in Treasuries and $291 billion in agency MBS. Garbade and Keane (2020) report cumulative Fed purchases between March 13 and July 31, 2020, amounting to $1.77 trillion of Treasuries and $892 billion of agency MBS.
After the U.S. Treasury market stabilized, the Fed continued significant asset purchases as part of its Quantitative Easing (QE) policy. The Fed, from June 2020 to October 2021, bought each month $80 billion of Treasuries and $40 billion of agency MBS. Between March 2020 and the end of QE4 in March 2022, it purchased just over $3.1 trillion of Treasuries and just over $1.3 trillion of agency MBS. This enabled a significant monetization of the additional federal borrowing that resulted from the (excessive) fiscal stimuli of the Covid years. In 2020 and 2021 six Covid-19 relief laws provided about $4.6 trillion of additional funding, of which $4.2 trillion had been spent by January 31, 2023.
Now for the howler: “The Federal Reserve purchases Treasury securities held by the public through a competitive bidding process. The Federal Reserve does not purchase new Treasury securities directly from the U.S. Treasury, and Federal Reserve purchases of Treasury securities from the public are not a means of financing the federal deficit.” The fact that the Fed purchases Treasury securities in the secondary market only and does not participate in Treasury auctions (the primary market) is of no economic significance. Purchases by the Fed, of Treasury securities from the public, finance the federal deficit just as direct purchases from the U.S. Treasury would. Additional (non-market) funding for the public debt is provided by an agency with a unique ability to issue monetary liabilities. It is an (indirect) means of financing the federal deficit.
Finally: “The Federal Reserve does not participate in competitive bidding at Treasury auctions, and the Treasury’s debt management decisions are not influenced by the Federal Reserve’s purchases of Treasury securities in secondary markets.” The first half of this quotation is correct but uninteresting. The statement “… the Treasury’s debt management decisions are not influenced by the Federal Reserve’s purchases of Treasury securities in secondary markets.” is clearly false. It does not say that the Treasury is operationally independent of the Fed (a reasonable assumption) but asserts that the Fed’s purchases of Treasury debt do not influence the size of the Treasury’s deficits or the composition of its financing. At the end of 2007, the size of the Fed’s balance sheet was $890 billion, of which $776 billion were Treasury securities. In March 2020, the Fed’s balance sheet was $4.61 trillion, of which $2.66 trillion were Treasury securities. In April 2022, the Fed’s balance sheet peaked at just under $8.95 trillion of which $5.76 trillion were Treasury securities. It is highly doubtful whether fiscal stimuli worth $4.2 trillion would have been undertaken following the Covid-19 outbreak if the Fed had not purchased $3.1 trillion worth of Treasury debt.
The Fragility of Independence
It is possible that the leading central banks believed (erroneously) that sovereign debt purchases and monetary issuance on the scale seen in the two years since the Covid outbreak were compatible with their price stability mandates and that there was no political pressure involved. In years to come, pressure (even overt) from fiscal authorities on notionally operationally independent central banks to purchase and monetize sovereign debt is likely in many advanced economies, including the US, given the massive increase in public debt and the rise in real interest rates. Few central banks will be able to resist. Those that resist will likely face legislative impairment of their operational independence or may have their mandates altered.
Central bank independence is a limited and fragile construct at best.
