The Fed is above the law
By Scott Sumner
This post may upset some people, but I am simply trying to describe the world as it is, not as I would wish it to be. I recently spoke with Ryan Hart, who is researching the legal status of Fed policy. That got me thinking about the Fed’s mandate, and whether it is legally enforceable.
The Fed is an independent agency, but not as independent as some other agencies. For instance, the Fed chair can be fired without cause, and that’s not true of some other agency heads. But in other respects, the Fed seems to be “above the law” in a way that is almost unique in the American system, at least as far as I know. (Please correct me if I am wrong.)
When agencies like the EPA decide on a new policy, such as calling CO2 a form of pollution, the decision often ends up in the courts. But that’s not true of Fed monetary policy decisions. Why not? My theory is that this seeming immunity from legal oversight is a product of the Fed’s strange history. It was not created to do what it currently does, which is target inflation.
Broadly speaking, Fed history can be divided up into three periods:
1. 1914-68: A gold price peg (actually two pegs).
2. 1968-81: The Great Inflation
3. 1982-present: Inflation targeting
Under the gold standard, a central bank is unable to target inflation at 2%, at least for any extended period of time. When the Fed was created, no one imagined that they would engage in inflation targeting. Thus no thought was given to a Fed mandate to stabilize the macroeconomy, although lawmakers certainly hoped that the lender of last resort provision would reduce banking instability.
During the 1970s, the Fed did have the power to control inflation. So why didn’t they? Their failure was due to the fact that the Fed, as well as most outside economists, didn’t realize that they could control inflation. Milton Friedman understood, but many Keynesians, even highly distinguished Keynesians, blamed inflation on everything except monetary policy—labor unions, budget deficits, oil shocks, even crop failures in the Soviet Union. Today these theories seem silly, but they were taken very seriously at the time. For some reason, almost no one connected the post-1965 orgy of money printing with the mid-1960s upswing in inflation:
In order to understand the Fed’s “dual mandate” you need to understand the time period in which it was enacted. In 1977, Congress gave the Fed a mandate for stable prices, high employment and moderate long-term interest rates. But Congress was not giving the Fed a target, they were essentially saying; “It would be nice if we lived in a world of stable prices and high employment; in the off chance that there is anything you guys at the Fed can do to make it happen, please do so.” I don’t think anyone in Congress seriously thought the Fed could just pick an inflation rate, like 2%, out of thin air and target it.
How did the Fed react after being given the mandate for “stable prices”? Here’s how:
Prices rose 60% in 5 years. Unemployment also rose in 1980, and longer-term interest rates hit an all time record of around 15% in 1981. I think it’s safe to say that these numbers are not what Congress had in mind. But no legal action was taken against the Fed, and indeed the Fed was not even blamed for the inflation. Again, the mandate was not viewed as a Fed target, and when the Fed sharply cut interest rates in the summer of 1980, despite 13% inflation, it was obvious to everyone that they were not targeting 2% inflation, and few people cared. (BTW, Paul Volcker did that insane easy money policy in mid-1980.) So if the courts were ever going to adjudicate a case against the Fed using the “original intent” approach, the Fed would win in a heartbeat. There was obviously no Congressional intent for the Fed to stop inflation.
Of course the Fed eventually did begin targeting inflation, at around 2% since 1990. But this was not because of the Congressional mandate, which as we saw the Fed ignored in 1980, but rather because they began to understand the ideas of Milton Friedman—persistent inflation is always and everywhere a monetary phenomenon. When the Fed succeeded, outside observers were stunned, flabbergasted. Almost no one had thought this was possible. Alan Greenspan (who liked to speak in cryptic ways) was viewed as some sort of a magician, a “maestro.” John McCain suggested that if Greenspan died his body ought to be propped up and kept in place, as in the film Weekend at Bernie’s.
Of course all this was wrong; keeping inflation close to 2% is easy, and other central banks also succeeded. Today many economists (including me) are horrified by the Fed missing on the low side by 1%, an accuracy that would have been viewed as mind-bogglingly impressive in the 1970s.
Because outsiders were impressed by the Fed’s success in controlling inflation, the Fed rose even further above the law. Now any outsider who wanted to tinker with the Fed was seen as a crackpot, and the Fed became a sort of mysterious temple, which is far above politics.
So that’s how we got to where we are today. Yes, in theory the Fed has a “mandate.” But in practice the Fed can do whatever it thinks best (obviously within reason) and no one will stop them. In practice, the Fed tends to adhere closely to the consensus view of mainstream macroeconomists, so any court case against the Fed would face the uphill battle, with the economics profession closing ranks around the Fed, perhaps even testifying in their favor. Lots of luck winning that sort of case in Federal court. Do you know any Federal judges that want to go down in history for having caused a Great Depression, or Great Inflation? Neither do I.
PS. This post describes the Fed’s role on monetary policy; nothing I said applies to banking regulation, which is much more political.