If this is August, it must be time to talk about overhauling the Federal Reserve.

Just a year ago, liberal Democrats on the Joint Economic Committee of Congress introduced legislation to abolish the Federal Open Market Committee, which sets Fed policy.

The bill would have reduced the presidents of the regional Federal Reserve banks to purely advisory roles. Predictably, the idea went nowhere.

Last week, Treasury Secretary Nicholas Brady - who should know better - gave new life to the proposal.

Hidden Agenda

Superficially, the debate is about changes in the Fed's structure and governance. However, the real objective is to make the Federal Reserve more responsive to political pressure.

That would lead to easier money in the short run and higher inflation in the long run.

Investors who claim that inflation and interest rates are headed for a sustained decline should pay attention. The reality is that Federal Reserve Chairman Alan Greenspan has zero support inside the Beltway for his crusade for zero inflation.

Should Congress start to tamper with the Fed in a serious way, no matter whether Mr. Bush or Mr. Clinton is in the White House, investors would have to move quickly to protect their capital.

The first thing to do would be reduce the maturity of fixed-income portfolios. In the extreme, investors might sell bonds short or buy put options on the bond future. Short sales and put options are market techniques to benefit from falling prices.

Misguided Strategy

Most critical, investors must remember what Washington has forgotten: By pumping up the money supply to force rates down, politicians would only push only bond prices down - and inflation and interest rates up.

The 12 regional Federal Reserve bank presidents have played key roles in keeping monetary policy on an anti-inflation track.

While they have only five of the 12 votes on the Federal Open Market Committee, they live and work in the real world, outside the Beltway. Members of the Federal Reserve Board, who are appointed by the President, have the other seven votes.

Politicians charge that the United States is the only major industrial nation whose central bank has policymakers not appointed by public officials.

Technically, this may be true. Legally, the regional Fed banks are owned by commercial banks in their districts. The presidents are selected by the directors of their banks with the approval of the Federal Reserve Board of Governors.

But the issue is irrelevant. The real question is political control.

A Classic Warning

In fact, the proposal to eliminate the Federal Open Market Committee is a scary one.

Thirty years ago, the privately funded Commission on Money and Credit made a similar suggestion. Congress rejected the idea then; it should do so again.

The late Allan Sproul, president of the New York Fed from 1941 to 1956, summed up the matter in a classic statement on central banking in the United States.

"The Federal Open Market Committee has become the heart of the Federal Reserve System; cut it out and you have a skeleton," he wrote in a letter to the Joint Economic Committee in 1961. "If you remove the presidents of the Reserve banks ... you will tear down the spirit and morale of the 12 banks."

Though unwise, the idea of eliminating the Open Market Committee was inevitable.

Mr. Greenspan doggedly pursued his grail of zero inflation long after the economy dipped into recession. He has wide support in the financial community, but little backing where it counts - on Capital Hill or in the White House.

In theory, Mr. Greenspan is right that "by ensuring stable prices, monetary policy can play its most important role in promoting economic progress."

The Real World

In practice, the Fed lives in the real world of politics, not the abstract one of economic science. Neither the White House nor Congress supports zero inflation as the Fed's principal goal. As a result, Mr. Greenspan's grail could become a booby trap.

Mr. Sproul once observed that the Fed is independent within the government but is not independent of the government. The Fed is not a fourth branch, ranking with the White House, Congress, or the judiciary. The Fed is a political institution, which cannot operate outside the national consensus for long.

Economist Milton Friedman, no slouch as an inflation fighter, warned recently that the Fed had been following "a policy which may well precipitate political interference and destroy it as an effective institution. Five years down the line, we could have a very substantial inflation."

Bills to overhaul the Fed - even if they go nowhere - are a signal for investor caution.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.