The important lesson from Federal Reserve news this week is a fundamental one: Our central bank system basically works well.
Regardless of Fed Chairman Ben Bernanke’s testimony before Congress or what the Fed’s Open Market Committee decides in three weeks, the compromise struck when the system was set up was a good one. It insulates monetary-policy decision-making from short-term political pressures while maintaining the Fed’s accountability to government.
This fundamental structure of the Fed is more important than the stock markets’ enthusiastic response Wednesday to Bernanke’s testimony — the Dow gaining almost 2 percent and the Nasdaq rising more than 1.8 percent. Traders obviously interpreted the chairman’s remarks to mean that the central bank is less likely to continue restricting growth of the money supply.
Less tightening means smaller increases in short-term interest rates and presumably fewer restraints on consumer spending and business investment. This is good economic news to the extent that inflation is under control. If it were not under control, however, a less restrictive policy merely provides short-term enjoyment at the expense of long-term pain.
Such fluctuations are much less important than the continued autonomy of the Fed. Consider a Bloomberg News story that appeared in the Pioneer Press and elsewhere Tuesday. It detailed how Republicans standing for re-election to Congress are getting antsy about whether the Fed will continue to constrict the money supply. They rightfully worry that the resulting higher interest rates might hurt the incumbent majority.
The comic relief that conservative Republicans provided by blasting the Fed with statements that might have been written by liberal Democrats is delicious to anyone with a sense of irony. More important, the Republicans’ panic shows that the Fed is doing what it is supposed to do — taking the political heat out of monetary policy-making.
In 1913, many saw that the nation needed a central bank. Democrats feared a private one modeled on the Bank of England that would be controlled by Wall Street. Republicans feared a government one influenced by short-term political pressures.
Both fears were justified. History shows that private monopolistic central banks like those originally in the United Kingdom and Sweden were not responsive to the needs of society as a whole. Experiences in Latin America demonstrate the dangers of central banks serving as electioneering tools.
Human nature and politics are such that candidates always will proclaim the need for lower interest rates during election campaigns. This is particularly true for incumbents. They conveniently ignore the fact that lower rates can only come with faster growth of the money supply and that too-rapid growth causes inflation.
The hyperinflation in Brazil and Argentina a decade ago and Mexico’s repeated financial crises since 1982 stemmed from central banks controlled by politicians. Latin America found it could only tame inflation by isolating central banks from politics, and the task is not yet complete.
In the United States, campaigners can fume and fuss and call Bernanke bad names all they want, but the posturing isn’t going to change what the FOMC does between now and the election. Ordinary citizens should be glad of that. The Fed has enough autonomy to take the political heat.
But while the Fed has great autonomy within the federal government, it is not autonomous from government. That is the important lesson from Bernanke’s testimony before the Senate on Wednesday and the House of Representatives today. The members of the Fed’s Board of Governors including its chairman and vice chairman are appointed by the president and confirmed by the Senate.
All the chairman has to do is report to Congress on a regular basis. He must sit and listen to all the comments and rebukes, however inane. But no law requires him to follow anyone’s orders.
Whether or not Bernanke’s testimony justifies Wall Street ebullience is of secondary importance. The important thing is that whatever the Fed decides at meetings on Aug. 8, Sept. 20 and Oct. 24, it will not be influenced by panicked politicians reading their poll numbers.
© 2006 Edward Lotterman
Chanarambie Consulting, Inc.