July 9 (Bloomberg) -- Federal Reserve Board Vice Chairman Donald Kohn said any “substantial erosion” of the central bank’s independence in setting interest rates may fuel investor fears of inflation and provoke higher long-term borrowing costs.

“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,” Kohn said in testimony at a House Financial Services subcommittee hearing today on Fed independence.

The Fed’s ability to act without political interference is at stake as Congress debates how to overhaul financial regulation following the worst credit crisis since the Great Depression. Some lawmakers advocate congressional audits of the central bank, while others are considering subjecting regional Fed presidents, who vote on interest rates, to Senate approval.

“History provides numerous examples of non-independent central banks being forced to finance large government budget deficits,” Kohn said. Higher rates may also “further increase the burden of the national debt on current and future generations,” Kohn said.

Kohn didn’t comment in his prepared testimony on the outlook for the economy or monetary policy.

Raising Rates

Responding to questions, the Fed vice chairman said the central bank will be able to raise interest rates in time to forestall a rapid acceleration of inflation, even though banks currently hold $687.7 billion in excess reserves as a consequences of the Fed pumping money into the stalled economy.

“We have an exit strategy from the provision of reserves that we have made, the very high level of reserves we now have in the system,” Kohn said. “We believe we have the tools to absorb those reserves, to raise interest rates, when the time comes to do so.”

Fed officials have made “no decision” on whether to expand their plan to buy $300 billion in longer-term Treasury securities in order to push down market interest rates, Kohn said. At the current rate of purchase, the program would end in late September, and any extension “would be a decision the Open Market Committee would have to make,” he said.

The vice chairman said the Fed is now more transparent than at any time since its creation almost a century ago. He cited steps this year to expand information on the Fed’s Web site on its programs and start a monthly report to Congress on the central bank’s emergency lending programs.

Fed Authority

Many lawmakers oppose an Obama administration proposal to expand the Fed’s powers to oversee the biggest financial companies. The proposal also seeks to curb the Fed’s authority to provide emergency loans to non-bank corporations after the central bank invoked a statute last year to bail out American International Group Inc. and Bear Stearns Cos.

Kohn told lawmakers that the administration’s proposal is a “natural outgrowth” of the Fed’s current regulatory responsibilities and would complement monetary policy.

“I believe that U.S. and foreign experience shows that monetary policy independence and supervisory and regulatory authority are mutually compatible and even have beneficial synergies,” Kohn said. Central banks “bring a broad and unique perspective to analysis” of the financial system, he said.

Bachus Objects

Representative Spencer Bachus of Alabama, the senior Republican on the Financial Services Committee, disagreed. “We particularly object to what we see as allowing the Fed to become a permanent bailout agency,” Bachus told Kohn at the hearing. “We believe that if that’s allowed to happen, that they will sacrifice their independence.”

Bachus and House Republicans are proposing to strip the Fed of supervisory powers and let non-bank financial firms fail in bankruptcy court.

Rather than allowing them to go bankrupt, Kohn reiterated the Fed’s view that a government agency -- other than the central bank -- should have the power to wind down systemically important non-banks.

“We need to have orderly resolution of these institutions, but that’s not the job of the Federal Reserve,” he said. “We would be consulting, we would be part of the process, but it ought to be a Treasury Department-led process.”

Voter concern that the Fed has overstepped its authority has prompted a majority of House lawmakers to co-sponsor a measure allowing for audits by the Government Accountability Office of the central bank’s monetary policy and other operations. Representative Ron Paul of Texas, who introduced the bill, is the senior Republican on the subcommittee.

Fed Independence

Such legislation is “contrary to the public interest” because investors may see it as “undermining monetary independence,” Kohn said. “Such an action would increase inflation fears and market interest rates and, ultimately, damage economic stability and job creation.”

A 1978 law prohibits the GAO from peering into Fed activities involving monetary policy or discount-window loans to banks. The GAO also is barred from auditing transactions with foreign governments, central banks and public international financing organizations, Kohn said. The GAO has the power to audit Fed bank-supervision activities and this year gained authority to examine Fed bailouts of companies such as AIG.

Kohn, 66, has worked at the Fed since joining the Kansas City bank as an economist in 1970. He became vice chairman in 2006 after serving as a governor and the top monetary-policy adviser. His term as vice chairman ends in June 2010.

Other Testimony

In a second part of the hearing, the panel is scheduled to hear a range of views from former Fed officials and other experts on the central bank.

Former Fed governors Laurence Meyer and Frederic Mishkin both support making the central bank the systemic risk regulator. Mishkin, a Columbia University professor who served from 2006 to 2008 and has collaborated on research with Chairman Ben S. Bernanke, said in prepared testimony that the Fed is a “natural” choice because of the “respect and independence” it enjoys.

Carnegie Mellon University Professor Allan Meltzer, author of a three-volume history of the Fed, disagrees, saying in his prepared text that the administration’s plan “sacrifices much of the remaining independence” of the central bank.

Instead, Meltzer recommended alternatives such as ending a policy that firms are “too big to fail,” and requiring banks to increase reserve capital.

To contact the reporter on this story: Scott Lanman in Washington at slanman@bloomberg.net.

Last Updated: July 9, 2009 17:08 EDT