Why the Fed Needs a Monetary Rule to Protect Its Independence

Screenshot of Trump Press Conference, AP: https://www.youtube.com/watch?v=_SxK-jOaaHw

As the 2020 presidential election season heats up, Federal Reserve Chairman Jerome Powell is being pushed from all sides. President Trump has castigated him for overly tight monetary policy and has implied that Powell is a “bigger enemy” than Xi Jinping.  Meanwhile, William Dudley, who recently headed the Federal Reserve Bank of New York, the most important reserve bank in the system, boldly called for Powell to enter the political fray against Trump and use a tighter monetary policy to help defeat him in 2020.

We’ve seen this pattern before—only this time, it’s more extreme. President Trump, like many executives before him, wants the Fed to sacrifice its independence in favor of more accommodative monetary policies, while Dudley, on the other hand, is willing to sacrifice the Fed’s independence in the short run.

The real problem is that, in our purely discretionary fiat money system, there is no rule to provide long-run guidance to monetary policymakers. This allows Congress to delegate too much power to the Fed and expect too much from it in return.  In conducting monetary policy, the Fed needs to be accountable to political institutions, yet independent of political pressures to finance budget deficits or use the printing press to satisfy special interests (whether those interests take the form of a border wall or a “Green New Deal”).

Only a rule—about how to track economic stability and how and when to respond to changes in that stability—can provide that independence.[1]

In a recent Wall Street Journal article, Paul Volcker, Alan Greenspan, Ben Bernanke, and Janet Yellen called for “nonpolitical” monetary policy “based on analysis of the longer-run economic interests of U.S. citizens rather than being motivated by short-run political advantage.”  They also called for “a robust public debate” to help “make monetary policy better.”

That debate is indeed necessary. And a significant part of it should focus on the relationship between Fed independence and a monetary rule—that is, whether the depoliticization of the Fed is more likely to occur under a regime of pure discretion or a rules-based regime. The answer seems clear. As Charles Calomiris, a member of the Shadow Open Market Committee, notes: “There are many levers that politicians can, and do, employ to influence monetary policy. True independence comes from making it harder for politicians to pull those levers.”

But the Fed has never managed yet to achieve genuine independence from politics.[2] When Alan Greenspan followed an implicit Taylor Rule (adjusting the fed funds, or interbank lending, rate in order to achieve steady nominal GDP growth), the economy flourished under a period now known as “the Great Moderation.” Politicization of the Fed was low and Fed independence was high. But when the Greenspan Fed departed from that rule in mid-2003, it erred by keeping interest rates too low for too long. Those low rates helped fuel the housing bubble and the growing subprime mortgage crisis.[3]

More recently, the Fed may have catered to pressures to favor housing finance by accumulating massive amounts of mortgage-backed securities. This meant the Fed began playing a major part in the allocation of credit as opposed to using pure monetary policy to achieve its inflation and employment goals.

Its continued reliance on unconventional monetary policy to offset the 2008 financial crisis finally resulted in a new operating framework in which the Fed sets its policy interest rate administratively and uses forward guidance to signal where the Fed thinks rates should go. But that guidance has been—and, in a free market, will always be—erratic as the Fed attempts to measure and respond to day-to-day changes in economic data and to financial markets.

Powell’s “pivot” after last December’s rate hike is a case in point.  The markets tanked and Powell immediately called for “patience,” followed by the first rate decrease since 2008. There is likely to be another rate cut this month, but not enough to satisfy President Trump, so the political pressure for easy money will continue.  Moreover, with growing budget deficits, the Fed will be expected to maintain a low interest rate policy.

The Fed’s so-called independence has always been tested by political pressures (see Cargill and O’Driscoll 2013), but those pressures became super-charged with the 2008 financial crisis, and have gained steam with President Trump’s tweeting storm and Dudley’s call for politicization. As the Fed reviews its strategy and communications this year, it should not forget two important points: (1) independence is necessary for the Fed to do its stabilization job well, free of presidential meddling; and (2) specific monetary rules may be the only sure means by which it can achieve such independence.

Just what sort of rule might protect the Fed’s independence while also being consistent with its mandate is of course another question that must also be addressed. Any rule can be shown to be inferior to some ideal of discretionary central banking. But it hardly follows that all monetary rules are inferior to discretion as actually practiced by the Fed, let alone as it might be practiced by central bankers who favor the use of discretion for avowedly political ends.

The problem is how to induce the Fed to trade off its discretionary powers and adopt a monetary rule that will decrease the uncertainty that now plagues the present system.  Congress has the authority to make the Fed accountable for following a rule, but thus far has not been able to even commence a national monetary commission to evaluate the Fed’s performance and recommend reforms.

This is a critical first step. Until then, it is imperative that we continue to examine alternative monetary rules so that, when the time is ripe, an effective rule-based monetary regime can be adopted to limit the power of the central bank, insulate it against political opportunism, and safeguard citizens’ right to sound money.


[1] See J. A. Dorn, “Myopic Monetary Policy and Presidential Power: Why Rules Matter.” Cato Journal 39 (3), forthcoming Fall 2019.

[2] See S. Binder and M. Spindel, The Myth of Independence: How Congress Governs the Federal Reserve.  Princeton, N.J.: Princeton University Press.

[3] See John B. Taylor, Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis.  Stanford, Calif.: Hoover Institution Press.


  1. Dudley's 8/27 piece in Bloomberg, arguing that "… Fed officials should consider how their decisions will affect the political outcome in 2020," was disastrous for Fed independence. The Fed should repeat over and over that it will not succumb to political pressure to help incumbents win the next election, even if it often is weak in that respect. But deliberately and explicitly sabotaging the economy for any purpose would amount to dereliction of duty. Trump can now credibly say, "See, Powell and his Fed cronies are out to defeat Trump."

  2. On Aug. 16, the Wall St. Journal published the following Letter to the Editor that I had sent them:

    Regarding Paul Volcker, Alan Greenspan, Ben Bernanke and Janet Yellen’s “America Needs an Independent Fed” (op-ed, Aug. 6): So long as the Fed sticks to central banking, i.e. monetizing a portion of the national debt with monetary base, it can expect to be an independent expert agency.

    However, when it expands its mandate into credit allocation, as it has since 2008, it becomes political and jeopardizes its independence.

    Since 2008, the Fed has paid interest on excess reserves, and purchased trillions of dollars of mortgages and long-term Treasuries. In so doing, it acts as a financial intermediary. If the Fed buys home mortgages, why not Social Security bonds, or green energy bonds? How many funds should be allocated to these and other activities should be decided by Congress and/or the market, not by the Fed.

    The maturity structure of the national debt is an important decision, made by the Treasury within the parameters set by Congress. By replacing long-term Treasuries with zero-maturity excess reserves, the Fed has in effect also usurped this function of the Treasury.

    Em. Prof. J. Huston McCulloch
    Ohio State University
    New York

  3. The best monetary policy for the Fed to follow is the real bills doctrine, which was developed by practical bankers over centuries of experience, and which was written into the Fed's original charter:

    "Money should be issued in exchange for short-term real bills of adequate value". Under this rule, a money-issuing bank passively issues new dollars who anyone who offers a dollar's worth of short term real bills in exchange. This automatically assures that the issuer's assets move in step with its issue of money, and at the same time, it assures that cash is automatically provided when liquidity is needed.

    1. The Real Bills Doctrine guarantees that banks will be liquid, but not that they will not overissue. So it's a good rule, but not sufficient for sound monetary policy.

    2. The Real Bills Doctrine guarantees that banks will be liquid, but not that they will not overissue. So it's a good rule, but not sufficient for sound monetary policy.

      1. The RBD assures that every time a bank issues a dollar, it will get a dollar's worth of new assets in return. Thus the bank's assets naturally rise in step with its money issue, and inflation is avoided. See my paper "The Real Meaning of the real Bills Doctrine"

  4. Fully agree with Dorn's thrust.

    Yet the truth is that when the chips are down (WWI, WWII, LBJ, Nixon, 2009, when SS/Medicare are broke), the Fed does the politicians' bidding. We have a politicized, anti-free-market system of money and banking. Good rules are better than bad ones, but ultimately a political and economically fascist (in the sense of intermingling of govt. and corp. interests) organization like the Fed will behave with political expediency regardless of rules.

    1. Spot on. Bernanke and Yellen protest too much. Previous administrations may have lacked the drama and Twitter, but the messages arrived at the Fed and the debt was monetized and credit allocated just as surely — and perhaps more so because it was all out of the public view.

  5. It is sacred canon among American macroeconomists and monetarists that a central bank should be independent. Yet this very independence is an affront to transparent democracy, and also a recipe for ossification. What better way to ensure that an organization becomes frozen in self-reverence, than by making it first a public organization, then an independent organization, then a self-financing organization?

    President Ronald Reagan advocated placing the Federal Reserve into the Treasury Department, where it would ultimately report to the Oval Office.

    Reagan's solution is transparent democracy. If I believe, as a voter, that inflation is too high or that the economy is too sluggish, I can vote my preferences.

    It is a reasonable fear that an independent central bank will chronically suffocate economic growth, or become a captured regulatory agency affiliated with the industries that it regulates.

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