Saturday, January 13, 2007

Will the Fed become less independent?

Today's Wall Street Journal reports:

Fed Chairman May Face Heat At Hearings

When Federal Reserve Chairman Ben Bernanke testifies on monetary policy next month, he is likely to get far more scrutiny than usual.

By law, the Fed chairman must testify twice a year to Congress: in February and July. Ordinarily, each installment lasts two days, one before the Senate Banking Committee, the other before the House Financial Services Committee. There are no other witnesses.

In a break with that tradition, Barney Frank, the Massachusetts Democrat who took over the House panel this month, said he plans to hold an additional day of hearings in which witnesses, such as economists and labor experts, will give their views on what Mr. Bernanke said.

The Fed is a creation of Congress, and the Congress surely has the right and duty to oversee the central bank. On the other hand, many economists have argued that an independent central bank performs better than one more closely tied to politics. A classic reference on the topic is Alesina and Summers. After reading a story like this, one might worry that more Congressional scrutiny will translate into less Fed independence and, if Alesina and Summers are right, worse macroeconomic outcomes.

Addendum: Here is a case study on the topic from my intermediate macroeconomics textbook:

Case Study
Central-Bank Independence

Suppose you were put in charge of writing the constitution and laws for a country. Would you give the president of the country authority over the policies of the central bank? Or would you allow the central bank to make decisions free from such political influence? In other words, assuming that monetary policy is made by discretion rather than by rule, who should exercise that discretion?

Countries vary greatly in how they choose to answer this question. In some countries, the central bank is a branch of the government; in others, the central bank is largely independent. In the United States, Fed governors are appointed by the president for 14-year terms, and they cannot be recalled if the president is unhappy with their decisions. This institutional structure gives the Fed a degree of independence similar to that of the U.S. Supreme Court.

Many researchers have investigated the effects of constitutional design on monetary policy. They have examined the laws of different countries to construct an index of central-bank independence. This index is based on various characteristics, such as the length of bankers' terms, the role of government officials on the bank board, and the frequency of contact between the government and the central bank. The researchers then examined the correlation between central-bank independence and macroeconomic performance.

The results of these studies are striking: more independent central banks are strongly associated with lower and more stable inflation. Figure 14-4 shows a scatterplot of central-bank independence and average inflation for the period 1955 to 1988. Countries that had an independent central bank, such as Germany, Switzerland, and the United States, tended to have low average inflation. Countries that had central banks with less independence, such as New Zealand and Spain, tended to have higher average inflation.

Researchers have also found there is no relationship between central-bank independence and real economic activity. In particular, central-bank independence is not correlated with average unemployment, the volatility of unemployment, the average growth of real GDP, or the volatility of real GDP. Central-bank independence appears to offer countries a free lunch: it has the benefit of lower inflation without any apparent cost. This finding has led some countries, such as New Zealand, to rewrite their laws to give their central banks greater independence.