Should Washington Tighten Its Grip on the Fed?

Rep. Barney Frank (D-MA), ranking member on the House Financial Services Committee, must not be pleased that the Federal Reserve plans to end its monetary stimulus next month. He introduced a bill (.pdf) this week that would kick regional Federal Reserve Bank presidents off the Federal Open Market Committee, the group that sets U.S. monetary policy. Instead, just Federal Reserve Governors, appointed by the President and confirmed by Congress, would be left to set monetary policy. This is an awful idea.

First, a brief explanation of the FOMC's structure might help. Currently, there are 12 members. Seven are governors, appointed by the President and confirmed the Senate. Five are regional Fed presidents. The New York president has a permanent seat and the other four rotate between the other 11 regional presidents.

Here's why Frank likes the idea, via Greg Robb at MarketWatch:

Their presence as voting members "it totally inconsistent with any kind of theory of democracy," Frank said.

"It undermines legitimacy when you have literally people who are in the financial industry picking people to vote on setting interest rates," Frank said.

However, Frank's motivation to kick the regional presidents off the FOMC could be political. Some of them tend to be hawkish on inflation, which means they are less likely to support very aggressive monetary stimulus. For example, Kansas City Fed President Thomas Hoenig became infamous for his regular dissenting votes last year when he sat on the FOMC. Although no regional presidents have dissented in 2011, a few -- especially Philadelphia Fed President Charles I. Plosser -- may object if others on the FOMC vote for another round of monetary stimulus.

This rationale is a poor one, for several reasons.

The Regional Presidents Don't Control the Vote

For starters, there's no point: even if all five regional Fed presidents that sit on the FOMC disagree with the seven Governors, it shouldn't matter. In a majority rule, seven beats five. So in effect, Washington already controls monetary policy; this action would just eliminate the possibility for vocal dissent by economists who monitor the U.S. from outside Washington.

You Lose the Voice of America

And that's a big problem. The nice thing about having regional presidents on the FOMC is that they bring a different perspective to monetary policy. The United States has a very complicated economy. What's going on in New York City isn't the same as what's going on in St. Louis, MO. Since economics is not a hard science, differing observations can create legitimate differences when concluding which policy is best for the nation on-a-whole.

Lost Independence

Moreover, this bill would threaten Fed independence. One of the reasons why the Federal Reserve is trusted to act in the nation's best interest is that it manages to stay further away from politics than Congress. This is due in large part to the presence of the regional Fed presidents. After all, the Governors are appointed and confirmed by politicians. Eliminating the regional presidents puts Congress one step closer to controlling monetary policy.

Shouldn't the Banking Industry Have Some Voice?

Frank complains that the financial industry picks the regional presidents, so they can't be trusted. What does this have to do with monetary policy? This would only be a meaningful criticism if there was a clear dissonance between a flourishing financial industry and the FOMC's objectives of low unemployment and stable prices. In fact, the two should generally walk hand-in-hand. When the economy is humming along, unemployment will be low and banking will have high profits. When the unemployment is high, those profits are lower than they would be if more Americans had jobs. Of course banks, which issue lots of debt, would not want high inflation either.

Frank's criticism could potentially matter here if big Wall Street banks, in particular, exerted strong influence over the Fed regional presidents. They don't. Of the twelve they only have a major impact on one: the New York Fed President. The other eleven answer mostly to smaller, regional banks. Their concern is Main Street, which matches up perfectly with the FOMC's mission to aim for stable prices and full employment. Indeed, some Fed regional presidents, like Hoenig, have even called for breaking up the big banks.

Does this bill have a shot? Usually, when a Republican Congress controls the House, controversial Democrat-sponsored legislation like this doesn't stand a chance. But this bill could be different. Hatred for Fed has become surprisingly bipartisan in recent years. The subcommittee on monetary policy is chaired by Rep. Ron Paul (R-TX), a tireless Fed critic. Moreover, some tea party supporters want to reign in the Fed. So other Republicans may also support an effort that would give Congress more control over central banking.

For now, it's unclear if the bill has legs, however. I contracted Rep. Paul's office a few times this week and did not receive a response on where he stood on the issue. But if the bill has his support, then it could move forward.