The Power and Importance of the Federal Reserve
The Federal Reserve is a powerful and critically important economic policy institution whose policy decisions have deep ramifications in the daily lives of working families. The decisions of the Federal Reserve have a significant impact on the overall level of economic activity, the trade deficit, the availability of jobs, wages and interest rates – including credit card rates, mortgage rates and the rate of interest paid by federal, state, and local government.
The main channels for these impacts are the Federal Reserve’s control over interest rates and its regulation of the banking and financial sectors. In exercising its control over interest rates, the Federal Reserve is guided by legislation that sets goals and grants the Federal Reserve powers to achieve those goals. However, the Federal Reserve retains significant discretion regarding the interpretation of those goals–for example, the definitions of full employment and price stability–and the policy actions needed to achieve them.
Fundamental Principles for Assessing Federal Reserve Nominees
Given the critical role of the Federal Reserve in economic policy-making and the significant impact its decisions have on the daily lives of working people, the AFL-CIO believes nominees to the Board of Governors should be appointed in accordance with the six fundamental principles listed below:
(1) Character and independence.
Nominees to the Board of Governors should be suited to public service. The Federal Reserve is a public institution with a vital public mission. Nominees should believe in that mission, which includes enforcement of regulation enacted by Congress, as well as a dual mandate of full employment and price stability.
In this regard, it is essential that nominees be independent of banking and financial sector interests. A core element of the Federal Reserve’s mission is to restrain speculative excess and uncompetitive impulses within the financial sector. Absent independence from the financial sector, nominees are likely to be biased and subject to pressure that compromises their decision-making.
(2) Experience and record.
The independence of Federal Reserve nominees is linked to experience. Nominees should have experience that suitably prepares them to serve as governors. This experience can be diverse, reflecting different understandings of the economy. However, the recent history of appointments to the Federal Reserve largely consists of individuals with backgrounds in finance and economics, which suggests a need to broaden the field of nominees.
Nominees whose experience is limited to Wall Street and the banking sector warrant special scrutiny. The perspectives of Wall Street and the financial sector are already overrepresented in the governance structure of the Federal Reserve and in lobbying activity surrounding it. Moreover, there is widespread agreement among observers of all political stripes that regulatory agencies are vulnerable to capture by the people and institutions that they are supposed to regulate. Because the Federal Reserve is supposed to regulate banks and Wall Street, the precautionary principle argues for exercising the greatest caution with regard to nominees from the financial sector.
Many recent appointees have been economists. Economists offer their professional credentials to justify their appointment. By the same token, economists should have to account for past positions on what constitutes full employment, predictions about inflation, recommendations on rate setting, and anticipation–or failure to anticipate–financial crises and stagnation.
(3) Commitment to full employment.
The Federal Reserve is mandated by law to seek maximum employment consistent with price level stability, which the Federal Reserve now defines as a stable inflation rate of two percent. Full employment is critical for shared prosperity because it gives working families the power to bargain for a share of increased productivity. The evidence on this point is clear: real wages rise when we are near or at full employment. The data also show that people at the bottom of the income scale – who are disproportionately African-Americans, Latinos and women–share in wage gains when we are at or near full employment.
In the past, too many economists have defined full employment as an unemployment rate of five to six percent, yet experience has shown that we are able to reach unemployment levels far lower than this. The views of these economists would have been very costly if they had held sway in the current recovery and expansion.
For all these reasons, nominees to the Federal Reserve should be committed to full employment. They should explain their views on full employment and how implementation of their thinking would have affected recent policy.
(4) Open-mindedness on inflation.
In addition to pursuing maximum employment, the Federal Reserve has a legal mandate to pursue price stability. On occasion, the dual mandates of full employment and price stability can be in conflict.
There is reason to believe that economists are pre-disposed to prioritize the price stability mandate of the Federal Reserve over full employment. First, the danger of expected future inflation is often invoked even when actual inflation is stubbornly low. Second, full employment is often characterized as a hair-trigger for inflation, and it is often claimed that the trigger corresponds to an unemployment rate of five or six percent.
Prioritizing price stability over full employment encourages damaging monetary policy tightness. Chairwoman Yellen and the current Board of Governors have done a good job resisting this kind of thinking during the current expansion, but we must ensure that the Federal Reserve continues to resist this kind of thinking in the future.
Furthermore, the question of price stability needs to be reconsidered. In the past, price stability has been defined as zero inflation. Now the Federal Reserve defines price stability as a stable inflation rate of two percent, the justification being that a higher inflation rate facilitates policy and improves economic performance. However, the economy may perform even better with a stable inflation rate of three or four percent, and nominees should be open to this possibility.
(5) Commitment to financial regulation.
The financial crisis of 2008 was intimately connected with financial excess on Wall Street and in the banking sector, where dangerous loopholes in financial regulation allowed large and interconnected institutions to engage in risky activities with little or no oversight or safety and soundness protections.
Our experience with the financial crisis has shown that the economy can be unstable even if macroeconomic performance appears sound–if destabilizing excess is accumulating within the financial sector.
All of this argues for effective regulation of the kind embodied in the Dodd-Frank Act. Nominees to the Board of Governors should acknowledge the potential for destabilizing excess in the financial sector and the need for countervailing regulation, which they should be committed to enforcing. Nominees must also be committed to completing implementation of the Dodd-Frank legislation by finalizing rules that are still outstanding.
(6) Discretion not rules.
Finally, some economists argue that Federal Reserve interest rate policy should be governed by a mathematical rule, rather than being set by informed discretion.
The mathematical rule approach would have failed terribly during the financial crisis because it would have failed to lower interest rates in a timely fashion. Similarly, this approach would have failed during the economic expansion because it would have raised interest rates long before reaching full employment, thereby inflicting huge damage to the cause of shared prosperity.
The economists who favor a mathematical interest rate rule also tend to oppose financial sector regulation. This point of view risks double damage. The ill-conceived application of an interest rate rule threatens to undermine the real economy, while opposition to financial sector regulation may allow destructive financial excess. Such ideologically driven thinking should not be an option at the Federal Reserve.
Summing Up
The Federal Reserve is a powerful and critically important institution whose policies can make or break shared prosperity. This is why it is essential that appointees to the Board of Governors have the character, experience, commitment, and intellectual understanding necessary for policymaking that fosters shared prosperity. Applying these six fundamental principles as a screen for potential nominees can help ensure this outcome.