An Open Letter to Jerome Powell
Dear Jay (if I may),
Next week you will be sworn in as the 16th chair of the Federal Reserve. After a brief ceremony -- not much chance of Champagne I fear -- it will be down to work, with your first Federal Open Market Committee meeting and press conference only six weeks away.
Could I offer a few words of advice? Conventional wisdom has it that the biggest challenge you'll face is how to withdraw the exceptional monetary stimulus of recent years without creating a market upset or another downturn. I disagree. I believe your legacy will depend on whether you succeed in protecting the Fed's independence.
I don't say this because I think monetary policy will be easy. The U.S. economy is doing well, with low unemployment, low inflation, and a respectable rate of growth -- but output, as elsewhere in the industrialized world, hasn't recovered nearly as strongly as expected since the crash. This combination of sustained ultra-low interest rates and a relatively tepid expansion isn't well understood. If there are remedies, they're likely to involve policies beyond the capability of central banks. These new uncertainties will complicate the Fed's task.
Regardless, to do the best job it can -- hard enough even under ordinary circumstances -- a central bank needs monetary policy to be shielded from day-to-day political pressures, and adequate powers to prevent a banking crisis from turning into a depression. Especially in the United States, this essential freedom of maneuver is being questioned. Dodd-Frank has already restricted the actions the Fed could take in the next financial crisis, and the administration is unlikely to disguise its feelings if your monetary-policy choices are politically inconvenient.
That's why I think the real test of your chairmanship will be to persuade Congress, and public opinion more widely, that delegating powers to the Fed -- within limits prescribed in advance by Congress, and with appropriate accountability for how those powers are exercised -- remains a vital public interest.
The Fed's experience shortly after the Second World War is instructive. From entry into the war in 1942 until 1951, the Fed was subservient to the Treasury. Its role was to help the U.S. government by maintaining low short-term interest rates and capping at 2.5 percent the interest rate on long-term bonds. As wartime controls were relaxed, this lack of freedom became an irritant for the Fed.
Following the start of the Korean War in 1950, tensions between the Fed and the Treasury increased: The Fed wanted to raise short-term rates and the Treasury was intent on issuing longer-term debt at low rates. Treasury talked about "stable rates" and the Fed about "stable markets." The inconsistency was all too apparent.
In January 1951, President Truman met with Treasury Secretary John Snyder and Fed Chairman Thomas McCabe to smooth things out. Nothing was resolved. But the next day, Snyder gave a speech dismissing monetary policy as a way to control inflation -- in effect, committing the Fed to a policy that most members of the FOMC no longer supported. The financial press backed the Fed.
At the end of the month, Truman invited the entire FOMC to meet with him -- the first and (so far) only meeting of this kind. As the economist and Fed historian Allan Meltzer wrote, "The meeting with the president smothered the conflict in ambiguity. Everyone seemed to agree, but no one changed position." 1 You no doubt have been to meetings like that yourself.
At the beginning of February, the White House and the Treasury leaked false claims that the Fed had agreed to keep rates down. One of the governors responded by leaking to the press the Fed's own record of the meeting with the president. Opinion rallied to the Fed. The FOMC was now in the driver's seat. It proposed ending its commitment to purchase long-term debt at rates above those desired by the Treasury and to use monetary policy to restrain inflation. Its wish to "normalize" monetary policy was incorporated into the Treasury-Federal Reserve Accord published on March 4, 1951.
Shortly after the accord was signed, Truman replaced McCabe with William McChesney Martin, a fellow Democrat, hoping that Martin would be more amenable to the administration's views. But the accord had made it easier for the Fed to pursue its mandate, and Martin set about doing exactly that. Truman was disappointed, as economist and banker Henry Kaufman notes in his recent book on the transformation of modern finance: 2
When President Truman and Bill Martin crossed each other’s paths quite coincidentally at the Waldorf-Astoria in late 1951, the Fed Chairman said "Good afternoon, Mr. President." The President looked Martin in the eye and replied with a single word: "Traitor."
So you know what to expect.
Today, some argue for relaxing the Fed's inflation goal of 2 percent; others would like to force the Fed to follow a rule for setting interest rates. Neither idea is attractive: There's no need to change the dual mandate or the inflation goal. What's important is for the country to recognize that the "constrained discretion" under which the Fed is accountable to Congress for discharging its mandate has served the country well. To that end, it's crucial to show that the Fed is a source of expertise and integrity, not a political actor.
Independence faces even greater pressure during and after financial crises. Dodd-Frank has limited the ability of the Fed to lend in "unusual and exigent circumstances" under section 13(3) of the Federal Reserve Act. And there are calls to ease the capital and liquidity requirements for banks adopted after the crash. These moves would make a future crisis more likely and more difficult to contain if it occurred.
Yet Congress is not wrong to express concern. It says that throwing unlimited amounts of money at a crisis is no use: If that is all you do, you'll end up throwing more and more money at crisis after crisis. And this in fact is a pretty good description of what has happened over the years.
Bank runs have been the Achilles' heel of private banks for centuries. In a crisis, the only sure source of liquidity is the central bank. The Fed must therefore be the provider of catastrophe insurance -- but it shouldn't provide that insurance free of charge, and when things do go wrong it mustn't be suspected of exceeding its remit.
The way to address this challenge is to establish a framework for emergency action ex ante, rather than handing down a rationale ex post. Much of the current antagonism toward the Fed stems from the fact that the extraordinary actions it took during and after the crash overstepped the mark that Congress believed it had laid down. This ambiguity needs to be confronted. Congress and the public must agree that in a crisis the Fed will act decisively, within broad rules already established, and with banks charged in good times for the right to access emergency lending in bad times.
An earlier populist president, Andrew Jackson, destroyed the Second Bank of the United States by vetoing its re-charter in 1832. The Bank had unwisely become a rival power center to the White House. As Jackson aptly wrote in his veto message, "It is to be regretted that the rich and powerful too often bend the acts of government to their selfish purposes."
Jackson saw himself as representing the people, and the Bank as a tool of the elite. For today's Fed, you must reverse the same perception. Position the Fed as the supporter of ordinary Americans against the ills of inflation, unemployment and the excesses of the financial sector -- not as a political player in its own right, but as a disinterested force, exercising its delegated authority under the instructions of Congress.
In these distrustful times, the central banker's most important task is to explain -- and educate. Congress and the political class more generally must be persuaded that the Fed needs certain powers to manage the economy and handle crises, and that there are limits to the Fed's freedom. "Constrained discretion" is the right approach, but this idea needs to be further developed and then defended.
This will require some back-to-basics thinking -- which leads me to my last recommendation. Here I'm passing on the advice given me by Alan Greenspan before I became governor of the Bank of England. Keep half of the time in your calendar free to read and think.
In his "Inventing a Nation," Gore Vidal describes a conversation with President Kennedy. He writes that Kennedy wondered: "[H]ow do you explain how a sort of backwards country like this, with only 3 million people, could have produced the three great geniuses of the 18th century -- Franklin, Jefferson, and Hamilton?"
"Time. They had more of it," Vidal replied. "They stayed home on the farm in winter. They read. Wrote letters. Apparently, thought, something no longer done -- in public life." 3
You may not have time to sip Champagne at your swearing in, but I hope that in the months and years ahead you will find time to read and think. I found that advice invaluable, and I hope you will too.
I wish you every success as chair of the Federal Reserve.
Yours ever, Mervyn
Allan Meltzer (2009): "A History of the Federal Reserve, Volume 1: 1931-1951."
Henry Kaufman (2016): "Tectonic Shifts in Financial Markets: People, Policies and Institutions."
Gore Vidal (2003): "Inventing a Nation."
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Clive Crook at firstname.lastname@example.org