Fight for FRS: why the Congress shouldn't interfere with regulator policy

Tuesday, 06 January 2015 11:42

The bill of restriction of powers of the Federal Reserve is actively discussed by congressmen. Why the House of Representatives controlled by republicans shouldn't accept it yet?

The U.S. Federal Reserve battles to congressmen because of the project "Act of the accountability and transparency" of FRS that will demand from the regulator of observance of more accurate rules of carrying out a monetary policy. FRS is afraid that the law will limit its independence, and supporters of the project claim that it will help to pass to sustained economic growth at low inflation. Who is right? To find the answer to this question, we will compare degree of independence of FRS, Bank of England and European Central Bank.

The Bank of England has a "tool", but not "target" independence. It means that the Minister of Finance sets the purpose on inflation and leaves to bank to solve how to reach the necessary level. If the deviation from the purpose exceeded percentage point, the managing director of Bank of England has to explain why it occurred and what the bank suggests to undertake in this situation.

And here the Maastricht contract set the task of maintenance of "stability of the prices" for European Central Bank, but left on its discretion definition of this concept. The European Central Bank decided that stability of the prices — is an annual rate of inflation slightly lower than 2%.

The structure of the European currency Union is such that there’s not any state supervision over European Central Bank.

Thus, the bank possesses both "target", and "tool" independence, though with some restrictions.

FRS is "independent", but only in the relations with executive power. The U.S. President can charge to the Ministry of Trade or the Ministry of Finance to take these or those measures (if they don't contradict the legislation), but has no right to specify FRS how to operate interest rates.

But it is independence from the White house, but not from the congress. FRS was created according to the decision of legislature with "the double mandate" — to provide price stability and the maximum employment. Thus FRS has the right to formulate working definitions of these purposes and methods of their achievement. However the offered bill will put the regulator in closer framework.

FRS considers that price stability — is 2% of annual inflation. For the last 12 months growth rates of the prices were about 1,5%. The desirable employment rate is definitely not defined, many economists consider that it corresponds 5,5% of unemployment. According to the latest data it makes 6,1%.

Because of fears that the long period of low interest rates will lead to inflation jump, the law demands from FRS to accept formal procedure of installation of a key short-term interest rate of federal funds rate. "Percentage rule" (Reference Policy Rule) is introduced, thus FRS has to explain to the congress each case of a deviation from the rule.

In fact, such order was offered in 1993 by John Taylor from Stanford University. He was guided by the statistical analysis of actions of heads of FRS Paul Volcker and Alan Greenspan at the time of low inflation and unemployment. Taylor considered that the rate on federal funds has to be 2% higher than the current rate of inflation, plus a half of a difference between the current and target rate of inflation and a half of a percentage difference between the nominal volume of GDP in the conditions of the current and full employment. Thus, if the full employment is reached and the target rate of inflation is supported, the rate on federal funds has to be 2% plus inflation. It has to be higher if inflation exceeded target level, and lower if GDP is less than in the conditions of a full employment.

Considering uncertainty concerning a full employment, this rule leaves a considerable freedom of action for FRS. The regulator can tell that the gap between real and potential GDP is more, than it is shown by data on unemployment, for example, because of a large number of the workers having part-time. If this size reaches 4% of GDP as show the latest data of the budgetary management of the congress, by Taylor's rule about 1,25% (2 + 1,5 – 0,25 – 2), but not 0,1%, as now would be an optimum interest rate for federal funds.

If in the next year or year and a half the rate is 1% higher, the gap between real and potential GDP can decrease that by Taylor's rule has to lead to even bigger increase of a rate. But because of the policy of "quantitative mitigation" pursued by FRS it only stimulates banks to accumulate reserves. Actually key rate of FRS will turn into a rate on excess reserves.

The offered bill is full of excess and impracticable conditions, and the House of Representatives controlled by Republicans shouldn't adopt it. The democratic senate anyway won't pass the law.

But the situation will change if republicans receive the majority in the senate on the following elections, and in the White house after 2016 there will be a republican president.

FRS, undoubtedly, is afraid of restrictions in carrying out a monetary policy therefore Janet Yellen opposes the bill so resolutely.

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