Given the release Friday of the semiannual report on Federal Reserve policy to Congress, it’s a good time to consider how to make the oversight process more useful. There has been much talk in recent years about making the Fed more transparent and accountable.
Unfortunately, the proposals that garner the most interest, like the Fed Oversight Reform and Modernization (FORM) Act, have two basic flaws: They fail the accountability test, and Congress is unlikely to enact them into law.
We should consider a different approach, one based on well-developed principles of organizational oversight.
In 1978, Congress gave the Fed a dual mandate to achieve stable prices and high employment. The Fed since clarified those goals to be a 2-percent rate of inflation and unemployment close to the “natural rate,” which occurs when the economy is in equilibrium.
While one can argue with the Fed’s interpretation of the law, there’s been surprisingly little effort in Congress to set an alternative inflation target.
However, the problems with accountability and transparency lie elsewhere. It’s unclear what sort of outcome the Fed prefers when it’s not possible to simultaneously hit the inflation and unemployment targets.
To make matters worse, it’s not clear when the Fed’s previous policy decisions were mistaken and contributed to macroeconomic instability. In fact, many economists believe the Fed worsened conditions during the 1930s Great Depression and the Great Inflation of 1966-81.
To be politically acceptable, a system of accountability shouldn’t interfere with Fed independence. Instead, the Fed should self-evaluate its past policy decisions to determine whether previous policy settings were appropriate. All organizations should learn from past mistakes to improve future decision-making.
Such a system should also involve a reporting procedure that makes it easier for Congress to understand what the Fed is trying to do, whether it succeeded or whether it fell short and why.
Think of the Fed as the captain of a ship steering toward a particular destination. The ship is buffeted by wind and waves, and the captain sets the steering wheel at a position that’s expected to offset those “shocks” and deliver the ship safely into port.
If the ship misses its destination, the shipping company would ask the captain to explain any mistakes. Was the steering wheel set to the wrong position? Were the wind and waves so strong that no setting could have offset their effects?
Similarly, the Fed faces macroeconomic shocks that can push the economy toward recession or high inflation. It uses tools such as short-term interest rates and quantitative easing to set a policy course aimed at achieving its mandate.
Over time, the inflation and unemployment data tell us whether previous policy settings were too expansionary or too contractionary.
Periodic reports to Congress as to the effectiveness of previous policy decisions would make for a nice starting point. The Fed would describe whether previous policy settings were too expansionary or too contractionary, and— more importantly — provide specific data on inflation, unemployment and related variables that allowed them to reach that judgment.
Those metrics are crucial. If the Fed weren't required to specifically explain its self-evaluation, it might be tempted to offer bland assurances that previous policy was appropriate.
Thus in 2009, the Fed would likely have indicated that, in retrospect, policy had been too contractionary during 2008, so it should have cut interest rates more rapidly. It would have trouble defending any claim that previous policy settings had been appropriate without becoming the subject of ridicule.
After all, the 0-percent inflation and 10-percent unemployment of 2009 weren’t desirable outcomes, and a more expansionary policy in 2008 would have pushed both inflation and employment up closer to the Fed’s targets. Former Fed Chair Ben Bernanke admitted as much in his memoir.
Under this scenario, the Fed would also have had the option of arguing that a more expansionary policy would indeed have been desirable, but that they lacked the necessary tools to do more.
Congress could then decide whether to give the Fed more effective resources to get the job done, such as the ability to purchase unconventional assets or to set negative interest rates.
Quite simply, the goal should be to make it easier for Congress, the broader public, and the markets to understand what the Fed is trying to do, why they take the actions they do, and whether those actions are effective.
The Fed itself stands to benefit as much as anyone. Its officials have sometimes complained about criticism for necessary-but-controversial steps to help the economy.
If this system of data-driven evaluation were in place, the Fed could essentially tell Congress: “Look, you gave us this dual mandate. The data show we are falling short (or overshooting) our goals. Therefore we clearly need a more expansionary (or contractionary) policy. That’s why we acted.”
is the Ralph G. Hawtrey chair of Monetary Policy with the Mercatus Center at George Mason University and author of “ .”