Fed’s Kohn on Central Bank’s Independence

Testifying before the Subcommittee on Domestic Monetary Policy and Technology, Donald Kohn, the number-two official at the Fed, urged Congress to respect the central bank’s independence to conduct monetary policy. In his testimony, Kohn argued that greater Congressional oversight to an already well-calibrated system of checks and balances in the form of transparency and accountability to the public and the Congress, would hurt the economy by unsettling financial markets. Kohn also strongly opposed the idea to give the General Accounting Office broader authority to examine the Fed’s conduct of monetary policy.

Here are a few excerpts from Kohn’s remarks:

From the Fed:

The insulation from short-term political pressures–within a framework of legislated objectives and accountability and transparency–that the Congress has established for the Federal Reserve has come to be widely emulated around the world. Considerable experience shows that this type of approach tends to yield a monetary policy that best promotes economic growth and price stability. Operational independence–that is, independence to pursue legislated goals–reduces the odds on two types of policy errors that result in inflation and economic instability. First, it prevents governments from succumbing to the temptation to use the central bank to fund budget deficits. Second, it enables policymakers to look beyond the short term as they weigh the effects of their monetary policy actions on price stability and employment.

History provides numerous examples of non-independent central banks being forced to finance large government budget deficits. Such episodes invariably lead to high inflation. Given the current outlook for large federal budget deficits in the United States, this consideration is especially important. Any substantial erosion of the Federal Reserve’s monetary independence likely would lead to higher long-term interest rates as investors begin to fear future inflation. Moreover, the bond rating agencies view operational independence of a country’s central bank as an important factor in determining sovereign credit ratings, suggesting that a threat to the Federal Reserve’s independence could lower the Treasury’s debt rating and thus raise its cost of borrowing.

In a democracy, any significant degree of independence by a government agency must be accompanied by substantial accountability and transparency. The Congress and the Federal Reserve have established a number of policies and procedures to ensure that the Federal Reserve continues to use its operational independence in a manner that promotes the nation’s well-being.

Our financial controls are examined by an external auditor, and Reserve Bank operations and controls are reviewed by each Reserve Bank’s independent internal audit function and by Board staff who oversee Reserve Bank activities. We provide the public and the Congress with detailed annual reports on the consolidated financial activities of the Federal Reserve System that are audited by an independent public accounting firm. We also publish a detailed balance sheet on a weekly basis.

The Federal Reserve recognizes that the new programs we have instituted to combat the financial crisis must be accompanied by additional transparency. Americans have a right to know how the Federal Reserve is using taxpayer resources and they need to be assured that we are acting in a responsible manner that minimizes risk and maintains the integrity of our operations. We have increased the transparency of our actions while safeguarding our ability to achieve our public policy goals of fostering financial and economic stability. This year we expanded our website to include considerable background information on our financial condition and our policy programs. Recently, we initiated a monthly report to the Congress and the public on Federal Reserve liquidity programs that provides even more information on our lending, the associated collateral, and other facets of programs established to address the financial crisis. These steps should help the public understand the considerable efforts we have taken to minimize the risk of loss as we provide liquidity to the financial system in our role as lender of last resort.

On the Oversight by the Government Accountability Office Kohn said:

[T]he possibility of expanding the audit authority of the Government Accountability Office (GAO) over the Federal Reserve has recently been discussed. As you know, the Federal Reserve is subject to frequent audits by the GAO on a broad range of our functions.

For example, the supervisory and regulatory functions of the Federal Reserve are subject to audit by the GAO to the same extent as the supervisory and regulatory functions of the other federal banking agencies. Thus, the GAO has full authority to–and does in fact–audit the manner in which the Federal Reserve supervises and regulates bank holding companies on a consolidated basis. Moreover, if the Congress were to provide the Federal Reserve with responsibility for serving as the consolidated supervisor of systemically important financial firms that are not bank holding companies, the GAO would, under existing law, have full authority to audit the Federal Reserve’s supervision and regulation of such firms as well. We would expect the GAO to actively use that authority, as it does today…

The Congress also recently clarified the GAO’s ability to audit the Term Asset-Backed Securities Loan Facility (TALF), a joint Treasury-Federal Reserve initiative, in conjunction with the GAO’s reviews of the performance of Treasury’s Troubled Asset Relief Program (TARP). The Federal Reserve has been working closely with the GAO to provide that agency with access to information and personnel to permit it to fully understand the terms, conditions, and operations of the TALF so that the TARP can be properly audited. At the same time, the Congress granted the GAO new authority to conduct audits of the credit facilities extended by the Federal Reserve to “single and specific” companies under the authority provided by section 13(3) of the Federal Reserve Act, including the loan facilities provided to, or created for, American International Group and Bear Stearns. These facilities are markedly different from the widely available credit facilities–such as the discount window access for depository institutions, the Primary Dealer Credit Facility, and the Commercial Paper Funding Facility–that the Federal Reserve either has historically used or has recently established to address broad credit and liquidity issues in the financial system. For this reason, the Federal Reserve did not object to granting the GAO audit authority over these institution-specific, emergency credit facilities.

The Congress, however, has purposefully–and for good reason–excluded from the scope of potential GAO audits monetary policy deliberations and operations, including open market and discount window operations, and transactions with or for foreign central banks, foreign governments, and public international financing organizations. By excluding these areas, the Congress has carefully balanced the need for public accountability with the strong public policy benefits that flow from maintaining the independence of the central bank’s monetary policy functions and avoiding disruption to the nation’s foreign and international relationships.

The same public policy reasons that supported the creation of these exclusions in 1978 remain valid today. The Federal Reserve strongly believes that removing the statutory limits on GAO audits of monetary policy matters would be contrary to the public interest by tending to undermine the independence and efficacy of monetary policy in several ways. First, the GAO serves as the investigative arm of the Congress and, by law, must conduct an investigation and prepare a report whenever requested by the House or Senate or a committee with jurisdiction of either body. Through its investigations and audits, the GAO typically makes its own judgments about policy actions and the manner in which they are implemented, as well as recommendations to the audited agency and to the Congress for changes or future actions. Accordingly, financial markets likely would see the grant of audit authority with respect to monetary policy to the GAO as undermining monetary independence….particularly because GAO audits, or the threat of a GAO audit, could be used to try to influence monetary policy decisions.

Permitting GAO audits of monetary policy also could cast a chill on monetary policy deliberations through another channel. Although Federal Reserve officials regularly explain the rationale for their policy decisions in public venues, the process of vetting ideas and proposals, many of which are never incorporated into policy decisions, could suffer from the threat of public disclosure. If policymakers believed that GAO audits would result in published analyses of their policy discussions, they might be less willing to engage in the unfettered and wide-ranging internal debates that are essential to identifying the best possible policy options. Moreover, the publication of the results of GAO audits related to monetary policy actions and deliberations could complicate and interfere with the communication of the FOMC’s intentions regarding monetary policy to financial markets and the public more broadly. Households, firms, and financial market participants might be uncertain about the implications of the GAO’s findings for future decisions of the FOMC, thereby increasing market volatility and weakening the ability of monetary policy actions to achieve their desired effects.

An additional concern is that permitting GAO audits of the broad liquidity facilities the Federal Reserve uses to affect credit conditions could reduce the effectiveness of these facilities in helping promote financial stability, maximum employment, and price stability. For example, even if strong confidentiality restrictions were established, individual banks might be more reluctant to borrow from the discount window if they knew that their identity and other sensitive information about their borrowings could be disclosed to the GAO. Rumors that a bank may have used the discount window can cause a damaging loss of confidence even to a fundamentally sound institution. Experience, including experience in the current financial crisis, shows that banks’ unwillingness to use the discount window can result in high and volatile short-term interest rates and limit the effectiveness of the discount window as a tool to enhance financial stability.

Overall, the Federal Reserve believes that removing the remaining statutory limits on GAO audits of monetary policy and discount window functions would tend to undermine public and investor confidence in monetary policy by raising concerns that monetary policy judgments in pursuit of our legislated objectives would become subject to political considerations. As a result, such an action would increase inflation fears and market interest rates and, ultimately, damage economic stability and job creation.

emphasis added

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