Fed Independence Must Be Preserved
Pressure is building at both ends of Pennsylvania Avenue to force Fed Chairman Alan Greenspan to cut interest rates and pump up the money supply.
To his credit, Mr. Greenspan has politely ignored such catcalls from the peanut gallery. This was a wise decision.
However, bankers must be alert to the possibility the central bank may cave in eventually.
The latest salvo came from Democrats on the Joint Economic Committee of Congress. Sen. Paul Sarbanes, D-Md., and Rep. Lee Hamilton, D-Ind., respectively chairman and vice chairman of the joint committee introduced legislation to abolish the Federal Open Market Committee, which sets Fed policy.
They would reduce the presidents of the regional Federal Reserve banks to purely advisory roles.
The presidents now have five votes on the FOMC, while members of the Federal Reserve Board have seven.
The Only Example
Rep. Sarbanes and Rep. Hamilton charged that the United States is the only major industrial nation whose central bank has some policy makers who are neither nominated nor appointed by public officials. Technically, regional Fed banks are owned by commercial banks in their districts. The presidents are selected by the directors of each reserve bank with the approval of the Federal Reserve Board.
The Sarbanes-Hamilton initiative to eliminate the FOMC is a hairy old idea. Just 30 years ago, the privately funded Commission on Money and Credit made a similar suggestion. The late Allan Sproul, president of the New York Fed from 1941 to 1956, summed up the matter in a classic analysis of central banking in the United States in a statement to the Joint Economic Committee in 1961:
"The Federal Open Market Committee has become the heart of the Federal Reserve System; cut it out and you have a skeleton. It is a unique development in central banking which has evolved out of the experience of the system with the needs of a country of the size and character of the United States.
"It is made up of men having statutory responsibilities, who serve on the committee as individuals under law and who are public officials and public servants in every real sense.
"The present constitution of the Federal Open Market Committee observes the cardinal principle of central banking: Those who determine monetary policy should not only coordinate their actions with the general economic policies of the government, but also should have a direct contact with the private money market.
"Such contacts come from living in the market, operating in the market, knowing the people in the market, and being able to feel the pulse of the market by hand from day to day, and not by random telephone calls or reviewing cold statistics."
A Committee of Equals
Mr. Sproul added that the FOMC had become the "forum where representatives of the constituent parts of the system - the reserve board and the reserve banks - meet as individuals and equals, bearing identical responsibilities under law to decide questions of high monetary policy."
However, unwise the Sarbanes-Hamilton initiative might be, it was inevitable. Mr. Greenspan has doggedly pursued his grail of zero inflation. In theory, he is right that "by ensuring stable prices, monetary policy can play its most important role in promoting economic progress." Zero inflation is indeed "a pre-requisite for maximizing economic growth and standards of living over time."
In practice, neither the White House nor Congress support zero inflation as the Fed's principal goal. As a result, Mr. Greenspan's grail could become a booby trap.
At present, a resolution is pending in Congress that would require the Fed to "adopt and pursue monetary policies leading to, and then maintaining, zero inflation." Even its sponsor, Rep. Stephen Neal, D-N.C., acknowledges the resolution has no chance.
Mr. Sproul once observed that the Fed was independent within the government but not independent of the government. Ultimately, the Fed is a political institution that cannot operate for long outside the national consensus.
Benjamin M. Friedman, professor of economics at Harvard, has the straight story:
"The written formalities of the Constitution and the Federal Reserve Act notwithstanding, in practice the Federal Reserve sets monetary policy within the gap spanned by the Administration's objectives on one side and whatever Congressional consensus exists on the other.
"Just how independent our central bank actually is varies over time, therefore, but its independence is always strictly limited.
"Hypothetical questions about the appropriateness of the central bank's pursuing an autarchic course, out of line with the remainder of the federal government overall, simply do not connect to the prevailing realities in the United States.
"The basic reality ... is the implicit threat of wholesale change [in Fed structure] by simple amendment to the Federal Reserve Act, should Administration and Congress agree on the need."
The Sarbanes-Hamilton initiative - even if it goes nowhere - is an unmistakable warning that Congress' attack has begun. Mr. Greenspan should have no difficulty winning confirmation for another four-year term. But he had better watch his step. Booby traps sometimes explode.
Unfortunately, senior officials in the Bush administration - who should know better - have been coconspirators in the effort to undermine the Fed.
Fears of Credit Crunch
White House chief economist Michael Boskin told the Joint Economic Committee the other day that "the availability of credit in the United States is probably the single biggest threat to a sustained recovery.
"The Fed is going to have to be prepared to add reserves to the system."
Bank reserves, of course, are raw material for the money supply. Whether pumping up the money supply would also help Mr. Bush's reelection campaign is a separate matter that Mr. Boskin did not discuss.
According to Mr. Boskin, 4.5% growth for M2 (currency, checking accounts and consumer thrift deposits) "would be satisfactory," but only if there is an increase in the turnover of money. The midpoint of the Fed's target for M2 in 1991-92 is 4.5%.
In reality, the high-powered money supply that truly matters for the economy - reserves and transaction balances - is already going up at a rapid pace.
The Fed shifted to an accommodative policy 10 months ago. Since then, total reserves have gone up at an annual rate of about 8%.
Indeed, this increase has been too fast to be sustained for long. At the moment, the real challenge facing the Fed may not be speeding up the money supply, but rather slowing it down.
Just try selling that one inside the Beltway.
Mr. Heinemann is chief economist of Ladenburg, Thalmann & Co., a New York investment banking firm.