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Informing the public about the Federal Reserve

Why is it important to separate Federal Reserve monetary policy decisions from political influence?

Policymakers, academics, and other informed observers around the world have reached broad consensus that the goals of monetary policy should be established by the political authorities, but the conduct of monetary policy in pursuit of those goals should be free from political influence.

Careful empirical studies support the view that central banks able to conduct day-to-day monetary policy operations free of political pressure tend to deliver better inflation outcomes, without compromising economic growth (see "Further Reading" below). And, while it is important to keep politics out of monetary policy decisions, it is equally important, in a democracy, for those decisions--and, indeed, all of the Federal Reserve's decisions and actions--to continue to be undertaken in a strong framework of accountability and transparency. The public and our elected representatives have a right to know how the Federal Reserve carries out its responsibilities.

To achieve its congressionally mandated goals of price stability, maximum employment, and moderate long-term interest rates, Federal Reserve policymakers must attempt to guide the economy, over time, toward a growth rate consistent with the expansion in its underlying productive capacity.

Because monetary policy works with time lags that can be substantial, achieving this objective requires that monetary policymakers take a longer-term perspective when making their decisions. Policymakers in an independent central bank, with a mandate to achieve the best possible economic outcomes in the longer term, are best able to take such a perspective.

In contrast, policymakers in a central bank subject to short-term political influence may face pressures to overstimulate the economy to achieve short-term output and employment gains that exceed the economy's underlying potential. Such gains may be popular at first, but they are not sustainable and soon evaporate, leaving behind only inflation that worsens the economy's longer-term prospects. Thus, political interference in monetary policy can generate undesirable boom-bust cycles that ultimately lead to both a less stable economy and higher inflation.

Political influence on monetary policy decisions can also impair the inflation-fighting credibility of the central bank, resulting in higher average inflation and, consequently, a less-productive economy.

Central banks regularly commit to maintaining low inflation in the longer term; if such a promise is viewed as credible by the public, then it will tend to be self-fulfilling, as inflation expectations will be low and so increases in wages would be the result of factors other than a need for households to adjust to a higher cost of living. Therefore, if inflation expectations are low, workers may temper their demands for higher wages, and then, if labor costs remain stable, firms may temper their demands for higher prices. On the other hand, a central bank subject to short-term political influences would likely not be credible when it promised low inflation, as the public would recognize the risk that monetary policymakers could be pressured to pursue short-run expansionary policies that would be inconsistent with long-run price stability. When a central bank's deliberations and actions are not deemed credible, businesses and consumers will expect higher inflation and, accordingly, workers will demand higher wages, and businesses will demand more-rapid increases in prices. Thus, a lack of central bank independence can lead to higher inflation and inflation expectations in the longer run, with no offsetting benefits in terms of greater output or employment. This outcome occurs because the maximum sustainable levels of output and employment are largely determined by non-monetary factors that affect the structure and dynamics of the economy.

Additionally, in some situations, a government that controls the central bank may face a strong temptation to abuse the central bank's money-creation powers to help finance government budget deficits. Abuse by the government of the power to issue money as a means of financing its spending inevitably leads to high inflation and interest rates and a volatile economy.

 

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Last update: March 3, 2015