Economy & Budget

The FORM Act will help the market — and the economy

Controversial legislation about how the Federal Reserve sets monetary policy could reach the floor of the House of Representatives this week, and for those of us who are not specialists in monetary policy the debate could be difficult to decipher.

The bill, called the Fed Oversight Reform and Modernization Act — FORM Act for short — deals with a lot of issues relating to the Fed’s management of U.S. monetary policy, but one element of the bill will receive most of the attention and commentary by monetary policy specialists. This is the bill’s requirement that the Fed publish a rule that would, in theory, explain what the Fed would do to achieve the twin goals of low inflation and economic growth. The Fed doesn’t have to follow the rule, but it must explain why it varies from the rule when it is does so.

{mosads}Opponents will argue that the rule — whatever it is — will compromise the Fed’s important independence. Proponents of the rule will contend that it forces the Fed to divulge the data it is using to set monetary policy and thus better inform the markets about what to expect in the future.

Why do we value the Fed’s independence? Monetary policy has major political consequences. For example, an inflationary policy — known as easy money — helps borrowers, because they can repay their loans in cheaper dollars, but tight money helps lenders, who may be paid in dollars that have more purchasing power than the dollars they lent. If the political party in power at any moment in time can direct that monetary policy follow its short term political interests — either favoring borrowers or lenders — the U.S. economy will suffer over the long term.

However, it is not necessary for the Fed’s independence that everything it does — and why it does it — be kept secret. In recent years, for example, after each meeting of the Federal Open Market Committee — the committee that actually makes monetary policy — the Fed has been issuing a statement that describes in general terms why it has decided to keep interest rates where they were, or why rates have been loosened or tightened. Years ago, the market didn’t even get these minimal signals.

After these statements, we see experts reading the Fed’s tea leaves, attempting to forecast what the Fed will do in the future by focusing on individual verbs, adjectives or nouns that might have changed from previous statements. This shows the markets’ hunger for information, but the fact that the Fed is saying something — rather than nothing — has not compromised its independence in any meaningful way.

Indeed, lack of information on something as important as monetary policy can be harmful to investors and to the economy as a whole, because investors and businesses deploy capital based on what they think will happen to interest rates in the future. The less information, the riskier these deployments are; the riskier they are, the more costly they are to make — which is why they may not be made at all. In addition, lack of information introduces unnecessary market volatility, as investors and businesses have to buy or sell securities — or even cancel contemplated transactions — because facts about the Fed’s policies have now come to light that show investors or businesses were operating on the wrong assumptions. This volatility is also costly for the economy.

In requiring the Fed to publish a rule, the FORM Act is intended to increase the information available to the market.

For example, if the rule — based on the information about the economy that is then available — would require that the Fed loosen its monetary policy and let interest rates decline, the Fed would have to explain why it did not follow the rule. It would have complete freedom not to follow the rule, but in explaining why it deviated from the rule, the Fed would provide useful information to the market as well as to Congress about what it foresees for the economy. It could also communicate its doubts about particular information that it used in making its decision.

This does not affect the Fed’s independence. The Federal Reserve would still be as independent as before, but Congress, investors and businesses would have much more information with which to make investments or pursue transactions.

Fed independence is important; it should never be compromised. But neither the Fed nor the opponents of the FORM Act should be able to use the danger of compromising the Fed’s independence to stop reforms that will provide more information to the market.

Wallison is the Arthur F. Burns Fellow in Financial Studies at the American Enterprise Institute. His most recent book is Hidden In Plain Sight: What Caused the World’s Worst Financial Crisis and Why It Could Happen Again (Encounter 2015)


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