To maintain the Fed’s independence in monetary policy and its ability to successfully fight inflation (and deflation) the Fed and the Treasury need to sign a Federal Reserve Credit Policy Accord, says economist Marvin Goodfriend. He offers six principles to guide such an accord.
By Robert Stowe England
April 25, 2009
A call for a Federal Reserve Credit Policy Accord between the Fed and the U.S. Treasury was issued yesterday (April 24) by Marvin Goodfriend, professor of economics and chairman of the Gailliot Center for Public Policy at the Tepper School of Business at Carnegie-Mellon University in Pittsburgh.
He was speaking at a symposium conducted by the Shadow Open Market Committee (http://www.somc.rochester.edu/) at Cato Institute in Washington, D.C.
Goodfriend’s concern was aimed at the Fed’s decision to provide more than $1 trillion of credit through the Term Asset Lending Facility (TALF) and other arrangements. The effort includes loans to banks and other financial institutions, as well as loans to special purpose entities to finance the acquisition of commercial paper and asset-backed securities.
These Fed lending efforts are “pure credit policy.” The endeavor is “therefore, taking a fiscal action and invading the territory of the fiscal authorities,” namely Congress and the U.S. Treasury, Goodfriend stated in his paper titled “We Need an ‘Accord’ for Federal Reserve Credit Policy.”
By expanding into fiscal matters, the Fed risks increased political interference that could undermine its ability to continue its successful management of monetary policy, including fighting the considerable inflationary policies that some are predicting from trillions of dollars of monetary and fiscal stimulus in the last six months, Goodfriend said.
Treasury and the Fed did, in fact, issued a four-point joint statement March 24 indicating agreement on the the role of the Federal Reserve in preserving financial and monetary stability, a step that garnered very little notice in the press at the time. The text of the statement can be found at this link: http://www.federalreserve.gov/newsevents/press/monetary/20090323b.htm
The joint statement concludes with a notice that ultimately the facilities set up by the Federal Reserve to improve the functioning of credit markets, known as the Maiden Lane facilities, should will be removed or liquidated by the U.S. Treasury.
Goodfriend said "it is a matter of urgency" to expand the March 24th agreement to include the six principles he outlined to the symposium.
The six principles are as follows:
1. As a long run matter, a significant sustained expansion of the Fed credit policy beyond ordinary, temporary last resort lending to banks is incompatible with sustained Fed independence. The Fed should adhere to a ‘Treasuries only’ asset acquisition policy except for occasional and limited discount window lending to banks.
2. The Treasury and the Fed should agree to co-operate, as soon as the current credit crisis allows, to shrink the central bank’s lending reach by letting Fed credit programs run off or by moving them from the Fed’s balance sheet to be managed elsewhere in the government. Any further expansion of Fed credit programs in the current credit crisis should be undertaken by agreement with Treasury to minimize the risk of committing to a course of action that proves subsequently to be ill-advised.
3. The Fed has employed monetary policy in the service of credit policy in the current emergency by creating over 1 trillion dollars of bank reserves to finance its credit policy initiatives, with the possibility of more to come before the credit crisis ends. The Treasury and the Fed should co-operate so that the Fed’s fiscal support through its credit policy initiatives for banking and credit markets does not undermine price stability.
4. To strengthen the nation’s commitment to price stability, the Treasury and the Fed should agree on a long run inflation objective to anchor inflation expectations against rising inflation or deflation. Such an agreement will not only improve the effectiveness of monetary policy, it will help hold down the inflation premium that the Treasury must pay to borrow long term.
5. The Treasury should help the Fed to secure the power of “interest on reserves” to put a floor under the federal funds rate. The Treasury and the Fed should do so by making sure that every institution that trades in the federal funds market holds deposits at the Fed and receives interest on these deposits as set by the Fed. This institutional fix is necessary to guarantee the Fed’s operational power to raise its federal funds rate target against inflation, regardless of the size of the Fed’s balance sheet. (See footnote)
6. The Treasury and the Fed should agree as soon as possible to co-operate as above to credibly secure the commitment to price stability so that the Fed can act preemptively, flexibly, and aggressively in the short run against either inflation, or a deepening contraction and deflation, whichever proves to be the greater risk. The credibility of monetary policy to act aggressively against deflation, if need be, depends crucially on the Fed having the power to raise interest rates against inflation if and when that should become the problem.
Marvin Goodfriend, “Interest on Reserves and Monetary Policy,” Federal Reserve Bank of New York Policy Review, (May 2002), pp. 77-84.
Copyright 2009© by Robert Stowe England