Legislation passed by the House of Representatives last week that would increase political oversight of the Federal Reserve could have significant economic costs.

The Fed should be held accountable, but the newly passed Fed Oversight Reform and Modernization Act runs the risk of politicizing the Fed and limiting the central bank's ability to respond to negative economic and financial shocks.

The proposed legislation isn't guaranteed to become law (there is chatter President Obama will likely veto it), but if the measure did become law, the Fed's reduced independence would be economically costly.

The legislation would require the Fed to adopt a mathematical formula for setting the fed funds rate. Rule-based monetary policy is a flawed idea, in part because of uncertainty about what rule should apply. The Fed itself doesn't know what an appropriate rule would say. Economic conditions are complex; specifying triggers or targets in advance risks leaving out important variables that can affect the policy.

Why the Fed Needs to Stay Flexible

The legislation would also make it difficult for the Fed to use its lender of last resort power, which was critical in easing the severity of the Great Recession, and would limit the central bank's ability to provide liquidity in a faltering credit system. The legislation would also allow an audit of FOMC policy decisions. This could lead to political business cycles, which impede growth in other countries. An independent Fed is a cornerstone of the U.S. economy.

The equilibrium fed funds rate will be lower than in the past, implying a limited scope for future rate cuts. Therefore, the Fed could retest the zero lower bound down the road, but lawmakers appear to be attempting to limit the Fed's tool kit. This could cause the next downturn to be worse than it should be and would shift the burden of supporting the economy from monetary to fiscal policy.

What are the policy options if the economy sputters and the Fed is forced to push interest rates back to zero? The Fed would initially lean on its unconventional but tested tools, including quantitative easing. Depending on the nature of weakening in the economy, the Fed could need to, if still available to them, revive its credit easing facilities. All options would be on the table, including negative interest rates.

Earlier this month Janet Yellen said that if the outlook were to deteriorate significantly, negative interest rates would be possible. Her comments were not a glowing recommendation, as it's unclear whether the benefits would exceed the costs.

Fed Approaching Point of No Return

Former Chairman Ben Bernanke recounts in his new book some of the policies the Fed considered but didn't implement during the Great Recession, including negative interest rates, funding for lending, raising the inflation target, and pegging interest rates on securities with maturities of two years or less. The latter would be a commitment to keep rates low for at least two years, but the balance sheet would increase substantially. He described nominal GDP targeting as a radical option.

The options Bernanke discussed could be the playbook if the Fed has to quickly reverse course, but the hope is that this won't be needed.

 

 

This article is commentary by an independent contributor. At the time of publication, the author held TK positions in the stocks mentioned.